Introduction
The Value of Stocks of a Company
The Process of Due Diligence
Financial Investor, Strategic Investor
The Myth of the Earnings Yield
Technical vs. Fundamental Analysis of Stocks
Volatility and Risk
The Bursting Asset Bubbles
The Future of the SEC
Privatizing with Golden Shares
The Future of the Accounting Profession
The Economics of Expectations
Anarchy as an Organizing Principle
The Pricing of Options
The Fabric of Economic Trust
The Distributive Justice of the Market
Notes on the Economics of Game Theory
The Spectrum of Auctions
Distributions to Partners and Shareholders
Moral Hazard and the Survival Value of Risk
The Agent-Principal Conundrum
Trading in Sovereign Promises
Portfolio Management Theory
Going Bankrupt in the World
The Author

Introduction
The securities industry worldwide is constructed upon the
quicksand of self-delusion and socially-acceptable
confabulations. These serve to hold together players and
agents whose interests are both disparate and
diametrically opposed. In the long run, the securities
markets are zero-sum games and the only possible
outcome is win-lose.
The first "dirty secret" is that a firm's market
capitalization often stands in inverse proportion to its
value and valuation (as measured by an objective, neutral,
disinterested party). This is true especially when agents
(management) are not also principals (owners).
Owing to its compensation structure, invariably tied to the
firms' market capitalization, management strives to
maximize the former by manipulating the latter. Very
often, the only way to affect the firm's market
capitalization in the short-term is to sacrifice the firm's
interests and, therefore, its value in the medium to longterm (for instance, by doling out bonuses even as the firm
is dying; by speculating on leverage; and by cooking the
books).
The second open secret is that all modern financial
markets are Ponzi (pyramid) schemes. The only viable
exit strategy is by dumping one's holdings on future
entrants. Fresh cash flows are crucial to sustaining ever
increasing prices. Once these dry up, markets collapse in a
heap.
Thus, the market prices of shares and, to a lesser extent

debt instruments (especially corporate ones) are
determined by three cash flows:
(i) The firm's future cash flows (incorporated into
valuation models, such as the CAPM or FAR)
(ii) Future cash flows in securities markets (i.e., the ebb
and flow of new entrants)
(iii) The present cash flows of current market participants
The confluence of these three cash streams translates into
what we call "volatility" and reflects the risks inherent in
the security itself (the firm's idiosyncratic risk) and the
hazards of the market (known as alpha and beta
coefficients).
In sum, stocks and share certificates do not represent
ownership of the issuing enterprise at all. This is a myth, a
convenient piece of fiction intended to pacify losers and
lure "new blood" into the arena. Shareholders' claims on
the firm's assets in cases of insolvency, bankruptcy, or
liquidation are of inferior, or subordinate nature.
Stocks are shares are merely options (gambles) on the
three cash flows enumerated above. Their prices wax and
wane in accordance with expectations regarding the future
net present values of these flows. Once the music stops,
they are worth little.
Return

The Value of Stocks of a Company
The debate rages all over Eastern and Central Europe, in
countries in transition as well as in Western Europe. It
raged in Britain during the 80s.
Is privatization really the robbery in disguise of state
assets by a select few, cronies of the political regime?
Margaret Thatcher was accused of it - and so were
privatizers in developing countries. What price should
state-owned companies have fetched? This question is not
as simple and straightforward as it sounds.
There is a stock pricing mechanism known as the Stock
Exchange. Willing buyers and willing sellers meet there to
freely negotiate deals of stock purchases and sales. New
information, macro-economic and micro-economic,
determines the value of companies.
Greenspan testifies in the Senate, economic figures are
released - and the rumour mill starts working: interest
rates might go up. The stock market reacts with frenzily it crashes. Why?
A top executive is asked how profitable will his firm be
this quarter. He winks, he grins - this is interpreted by
Wall Street to mean that profits will go up. The share price
surges: no one wants to sell it, everyone want to buy it.
The result: a sharp rise in its price. Why?
Moreover: the share price of a company of an identical
size, similar financial ratios (and in the same industry)
barely budges. Why not?

We say that the stocks of the two companies have
different elasticity (their prices move up and down
differently), probably the result of different sensitivities to
changes in interest rates and in earnings estimates. But
this is just to rename the problem. The question remains:
Why do the shares of similar companies react differently?
Economy is a branch of psychology and wherever and
whenever humans are involved, answers don't come easy.
A few models have been developed and are in wide use
but it is difficult to say that any of them has real predictive
or even explanatory powers. Some of these models are
"technical" in nature: they ignore the fundamentals of the
company. Such models assume that all the relevant
information is already incorporated in the price of the
stock and that changes in expectations, hopes, fears and
attitudes will be reflected in the prices immediately.
Others are fundamental: these models rely on the
company's performance and assets. The former models are
applicable mostly to companies whose shares are traded
publicly, in stock exchanges. They are not very useful in
trying to attach a value to the stock of a private firm. The
latter type (fundamental) models can be applied more
broadly.
The value of a stock (a bond, a firm, real estate, or any
asset) is the sum of the income (cash flow) that a
reasonable investor would expect to get in the future,
discounted at the appropriate rate. The discounting reflects
the fact that money received in the future has lower
(discounted) purchasing power than money received now.
Moreover, we can invest money received now and get
interest on it (which should normally equal the discount).
Put differently: the discount reflects the loss in purchasing
power of money deferred or the interest lost by not being

able to invest the money right away. This is the time value
of money.
Another problem is the uncertainty of future payments, or
the risk that we will never receive them. The longer the
payment period, the higher the risk, of course. A model
exists which links time, the value of the stock, the cash
flows expected in the future and the discount (interest)
rates.
The rate that we use to discount future cash flows is the
prevailing interest rate. This is partly true in stable,
predictable and certain economies. But the discount rate
depends on the inflation rate in the country where the firm
is located (or, if a multinational, in all the countries where
it operates), on the projected supply of and demand for its
shares and on the aforementioned risk of non-payment. In
certain places, additional factors must be taken into
account (for example: country risk or foreign exchange
risks).
The supply of a stock and, to a lesser extent, the demand
for it determine its distribution (how many shareowners
are there) and, as a result, its liquidity. Liquidity means
how freely can one buy and sell it and at which quantities
sought or sold do prices become rigid.
Example: if a controlling stake is sold - the buyer
normally pays a "control premium". Another example: in
thin markets it is easier to manipulate the price of a stock
by artificially increasing the demand or decreasing the
supply ("cornering" the market).
In a liquid market (no problems to buy and to sell), the
discount rate is comprised of two elements: one is the
risk-free rate (normally, the interest payable on

government bonds), the other being the risk-related rate
(the rate which reflects the risk related to the specific
stock).
But what is this risk-related rate?
The most widely used model to evaluate specific risks is
the Capital Asset Pricing Model (CAPM).
According to it, the discount rate is the risk-free rate plus
a coefficient (called beta) multiplied by a risk premium
general to all stocks (in the USA it was calculated to be
5.5%). Beta is a measure of the volatility of the return of
the stock relative to that of the return of the market. A
stock's Beta can be obtained by calculating the coefficient
of the regression line between the weekly returns of the
stock and those of the stock market during a selected
period of time.
Unfortunately, different betas can be calculated by
selecting different parameters (for instance, the length of
the period on which the calculation is performed). Another
problem is that betas change with every new datum.
Professionals resort to sensitivity tests which neutralize
the changes that betas undergo with time.
Still, with all its shortcomings and disputed assumptions,
the CAPM should be used to determine the discount rate.
But to use the discount rate we must have future cash
flows to discount.
The only relatively certain cash flows are dividends paid
to the shareholders. So, Dividend Discount Models
(DDM) were developed.
Other models relate to the projected growth of the
company (which is supposed to increase the payable

dividends and to cause the stock to appreciate in value).
Still, DDMâ&#x20AC;&#x2122;s require, as input, the ultimate value of the
stock and growth models are only suitable for mature
firms with a stable, low dividend growth. Two-stage
models are more powerful because they combine both
emphases, on dividends and on growth. This is because of
the life-cycle of firms. At first, they tend to have a high
and unstable dividend growth rate (the DDM tackles this
adequately). As the firm matures, it is expected to have a
lower and stable growth rate, suitable for the treatment of
Growth Models.
But how many years of future income (from dividends)
should we use in our calculations? If a firm is profitable
now, is there any guarantee that it will continue to be so in
the next year, or the next decade? If it does continue to be
profitable - who can guarantee that its dividend policy will
not change and that the same rate of dividends will
continue to be distributed?
The number of periods (normally, years) selected for the
calculation is called the "price to earnings (P/E) multiple".
The multiple denotes by how much we multiply the (after
tax) earnings of the firm to obtain its value. It depends on
the industry (growth or dying), the country (stable or
geopolitically perilous), on the ownership structure
(family or public), on the management in place
(committed or mobile), on the product (new or old
technology) and a myriad of other factors. It is almost
impossible to objectively quantify or formulate this
process of analysis and decision making. In
telecommunications, the range of numbers used for
valuing stocks of a private firm is between 7 and 10, for
instance. If the company is in the public domain, the
number can shoot up to 20 times net earnings.

While some companies pay dividends (some even borrow
to do so), others do not. So in stock valuation, dividends
are not the only future incomes you would expect to get.
Capital gains (profits which are the result of the
appreciation in the value of the stock) also count. This is
the result of expectations regarding the firm's free cash
flow, in particular the free cash flow that goes to the
shareholders.
There is no agreement as to what constitutes free cash
flow. In general, it is the cash which a firm has after
sufficiently investing in its development, research and
(predetermined) growth. Cash Flow Statements have
become a standard accounting requirement in the 80s
(starting with the USA). Because "free" cash flow can be
easily extracted from these reports, stock valuation based
on free cash flow became increasingly popular and
feasible. Cash flow statements are considered independent
of the idiosyncratic parameters of different international
environments and therefore applicable to multinationals or
to national, export-orientated firms.
The free cash flow of a firm that is debt-financed solely
by its shareholders belongs solely to them. Free cash flow
to equity (FCFE) is:
FCFE = Operating Cash Flow MINUS Cash needed
for meeting growth targets
Where:
Operating Cash Flow = Net Income (NI) PLUS
Depreciation and Amortization
Cash needed for meeting growth targets = Capital
Expenditures + Change in Working Capital

Working Capital = Total Current Assets - Total Current
Liabilities
Change in Working Capital = One Year's Working
Capital MINUS Previous Year's Working Capital
The complete formula is:
FCFE = Net Income PLUS
Depreciation and Amortization MINUS
Capital Expenditures PLUS
Change in Working Capital
A leveraged firm that borrowed money from other sources
(even from preferred stock holders) exhibits a different
free cash flow to equity. Its CFCE must be adjusted to
reflect the preferred dividends and principal repayments
of debt (MINUS sign) and the proceeds from new debt
and preferred stocks (PLUS sign). If its borrowings are
sufficient to pay the dividends to the holders of preference
shares and to service its debt - its debt to capital ratio is
sound.
The FCFE of a leveraged firm is:
FCFE = Net Income PLUS
Depreciation and Amortization MINUS
Principal Repayment of Debt MINUS
Preferred Dividends PLUS
Proceeds from New Debt and Preferred MINUS
Capital Expenditures MINUS
Changes in Working Capital
A sound debt ratio means:
FCFE = Net Income MINUS
(1 - Debt Ratio)*(Capital Expenditures MINUS
Depreciation and Amortization PLUS
Change in Working Capital)

Also Read:
The Myth of the Earnings Yield
The Friendly Trend - Technical vs. Fundamental
Analysis
The Roller Coaster Market - On Volatility and Risk

Return

The Process of Due Diligence
A business which wants to attract foreign investments
must present a business plan. But a business plan is the
equivalent of a visit card. The introduction is very
important - but, once the foreign investor has expressed
interest, a second, more serious, more onerous and more
tedious process commences: Due Diligence.
"Due Diligence" is a legal term (borrowed from the
securities industry). It means, essentially, to make sure
that all the facts regarding the firm are available and have
been independently verified. In some respects, it is very
similar to an audit. All the documents of the firm are
assembled and reviewed, the management is interviewed
and a team of financial experts, lawyers and accountants
descends on the firm to analyze it.
First Rule:
The firm must appoint ONE due diligence coordinator.
This person interfaces with all outside due diligence
teams. He collects all the materials requested and oversees
all the activities which make up the due diligence process.
The firm must have ONE VOICE. Only one person
represents the company, answers questions, makes
presentations and serves as a coordinator when the DD
teams wish to interview people connected to the firm.

Second Rule:
Brief your workers. Give them the big picture. Why is the
company raising funds, who are the investors, how will
the future of the firm (and their personal future) look if the
investor comes in. Both employees and management must
realize that this is a top priority. They must be instructed
not to lie. They must know the DD coordinator and the
company's spokesman in the DD process.
The DD is a process which is more structured than the
preparation of a Business Plan. It is confined both in time
and in subjects: Legal, Financial, Technical, Marketing,
Controls.
The Marketing Plan
Must include the following elements:
•

A brief history of the business (to show its track
performance and growth).

Comparison of the firm's products and services to
those of the competitors.

•

Warranties, guarantees and after-sales service.

•

Development of new products or services.

•

A general overview of the market and market
segmentation.

•

Is the market rising or falling (the trend: past and
future).

•

What customer needs do the products / services
satisfy.

•

Which markets segments do we concentrate on
and why.

•

What factors are important in the customer's
decision to buy (or not to buy).

•

A list of the direct competitors and a short
description of each.

•

The strengths and weaknesses of the competitors
relative to the firm.

•

Missing information regarding the markets, the
clients and the competitors.

•

Planned market research.

•

A sales forecast by product group.

•

The pricing strategy (how is pricing decided).

•

Promotion of the sales of the products (including a
description of the sales force, sales-related
incentives, sales targets, training of the sales
personnel, special offers, dealerships,
telemarketing and sales support). Attach a flow
chart of the purchasing process from the moment
that the client is approached by the sales force
until he buys the product.

Customer loyalty (example: churn rate and how is
it monitored and controlled).

Legal Details
•

Full name of the firm.

•

Ownership of the firm.

•

Court registration documents.

•

Copies of all protocols of the Board of Directors
and the General Assembly of Shareholders.

•

Signatory rights backed by the appropriate
decisions.

•

The charter (statute) of the firm and other
incorporation documents.

•

Copies of licences granted to the firm.

•

A legal opinion regarding the above licences.

•

A list of lawsuit that were filed against the firm
and that the firm filed against third parties
(litigation) plus a list of disputes which are likely
to reach the courts.

•

Legal opinions regarding the possible outcomes of

all the lawsuits and disputes including their
potential influence on the firm.
Financial Due Diligence
Last 3 years income statements of the firm or of
constituents of the firm, if the firm is the result of a
merger. The statements have to include:
•

Balance Sheets;

•

Income Statements;

•

Cash Flow statements;

•

Audit reports (preferably done according to the
International Accounting Standards, or, if the firm
is looking to raise money in the USA, in
accordance with FASB);

•

Cash Flow Projections and the assumptions
underlying them.

Controls
•

Accounting systems used;

•

Methods to price products and services;

•

Payment terms, collections of debts and ageing of
receivables;

•

Introduction of international accounting standards;

•

Monitoring of sales;

•

Monitoring of orders and shipments;

•

Keeping of records, filing, archives;

•

Cost accounting system;

•

Budgeting and budget monitoring and controls;

•

Internal audits (frequency and procedures);

•

External audits (frequency and procedures);

•

The banks that the firm is working with: history,
references, balances.

A successful due diligence is the key to an eventual
investment. This is a process much more serious and
important than the preparation of the Business Plan.

Return

Financial Investor, Strategic Investor
In the not so distant past, there was little difference
between financial and strategic investors. Investors of all
colors sought to safeguard their investment by taking over
as many management functions as they could.
Additionally, investments were small and shareholders
few. A firm resembled a household and the number of
people involved – in ownership and in management – was
correspondingly limited. People invested in industries
they were acquainted with first hand.
As markets grew, the scales of industrial production (and
of service provision) expanded. A single investor (or a
small group of investors) could no longer accommodate
the needs even of a single firm. As knowledge increased
and specialization ensued – it was no longer feasible or
possible to micro-manage a firm one invested in. Actually,
separate businesses of money making and business
management emerged. An investor was expected to excel
in obtaining high yields on his capital – not in industrial
management or in marketing. A manager was expected to
manage, not to be capable of personally tackling the
various and varying tasks of the business that he managed.
Thus, two classes of investors emerged. One type supplied
firms with capital. The other type supplied them with
know-how, technology, management skills, marketing
techniques, intellectual property, clientele and a vision, a
sense of direction.
In many cases, the strategic investor also provided the

necessary funding. But, more and more, a separation was
maintained. Venture capital and risk capital funds, for
instance, are purely financial investors. So are, to a
growing extent, investment banks and other financial
institutions.
The financial investor represents the past. Its money is the
result of past - right and wrong - decisions. Its orientation
is short term: an "exit strategy" is sought as soon as
feasible. For "exit strategy" read quick profits. The
financial investor is always on the lookout, searching for
willing buyers for his stake. The stock exchange is a
popular exit strategy. The financial investor has little
interest in the company's management. Optimally, his
money buys for him not only a good product and a good
market, but also a good management. But his
interpretation of the rolls and functions of "good
management" are very different to that offered by the
strategic investor. The financial investor is satisfied with a
management team which maximizes value. The price of
his shares is the most important indication of success.
This is "bottom line" short termism which also
characterizes operators in the capital markets. Invested in
so many ventures and companies, the financial investor
has no interest, nor the resources to get seriously involved
in any one of them. Micro-management is left to others but, in many cases, so is macro-management. The
financial investor participates in quarterly or annual
general shareholders meetings. This is the extent of its
involvement.
The strategic investor, on the other hand, represents the
real long term accumulator of value. Paradoxically, it is
the strategic investor that has the greater influence on the
value of the company's shares. The quality of

management, the rate of the introduction of new products,
the success or failure of marketing strategies, the level of
customer satisfaction, the education of the workforce - all
depend on the strategic investor. That there is a strong
relationship between the quality and decisions of the
strategic investor and the share price is small wonder. The
strategic investor represents a discounted future in the
same manner that shares do. Indeed, gradually, the
balance between financial investors and strategic investors
is shifting in favour of the latter. People understand that
money is abundant and what is in short supply is good
management. Given the ability to create a brand, to
generate profits, to issue new products and to acquire new
clients - money is abundant.
These are the functions normally reserved to financial
investors:
Financial Management
The financial investor is expected to take over the
financial management of the firm and to directly appoint
the senior management and, especially, the management
echelons, which directly deal with the finances of the
firm.
1. To regulate, supervise and implement a timely, full
and accurate set of accounting books of the firm
reflecting all its activities in a manner
commensurate with the relevant legislation and
regulation in the territories of operations of the
firm and with internal guidelines set from time to
time by the Board of Directors of the firm. This is
usually achieved both during a Due Diligence
process and later, as financial management is
implemented.

2. To implement continuous financial audit and
control systems to monitor the performance of the
firm, its flow of funds, the adherence to the
budget, the expenditures, the income, the cost of
sales and other budgetary items.
3. To timely, regularly and duly prepare and present
to the Board of Directors financial statements and
reports as required by all pertinent laws and
regulations in the territories of the operations of
the firm and as deemed necessary and demanded
from time to time by the Board of Directors of the
Firm.
4. To comply with all reporting, accounting and audit
requirements imposed by the capital markets or
regulatory bodies of capital markets in which the
securities of the firm are traded or are about to be
traded or otherwise listed.
5. To prepare and present for the approval of the
Board of Directors an annual budget, other
budgets, financial plans, business plans, feasibility
studies, investment memoranda and all other
financial and business documents as may be
required from time to time by the Board of
Directors of the Firm.
6. To alert the Board of Directors and to warn it
regarding any irregularity, lack of compliance,
lack of adherence, lacunas and problems whether
actual or potential concerning the financial
systems, the financial operations, the financing
plans, the accounting, the audits, the budgets and
any other matter of a financial nature or which
could or does have a financial implication.

7. To collaborate and coordinate the activities of
outside suppliers of financial services hired or
contracted by the firm, including accountants,
auditors, financial consultants, underwriters and
brokers, the banking system and other financial
venues.
8. To maintain a working relationship and to develop
additional relationships with banks, financial
institutions and capital markets with the aim of
securing the funds necessary for the operations of
the firm, the attainment of its development plans
and its investments.
9. To fully computerize all the above activities in a
combined hardware-software and communications
system which will integrate into the systems of
other members of the group of companies.
10. Otherwise, to initiate and engage in all manner of
activities, whether financial or of other nature,
conducive to the financial health, the growth
prospects and the fulfillment of investment plans
of the firm to the best of his ability and with the
appropriate dedication of the time and efforts
required.

Collection and Credit Assessment
1. To construct and implement credit risk assessment
tools, questionnaires, quantitative methods, data
gathering methods and venues in order to properly
evaluate and predict the credit risk rating of a
client, distributor, or supplier.
2. To constantly monitor and analyse the payment
morale, regularity, non-payment and nonperformance events, etc. â&#x20AC;&#x201C; in order to determine
the changes in the credit risk rating of said factors.
3. To analyse receivables and collectibles on a
regular and timely basis.
4. To improve the collection methods in order to
reduce the amounts of arrears and overdue
payments, or the average period of such arrears
and overdue payments.
5. To collaborate with legal institutions, law
enforcement agencies and private collection firms
in assuring the timely flow and payment of all due
payments, arrears and overdue payments and other
collectibles.
6. To coordinate an educational campaign to ensure
the voluntary collaboration of the clients,
distributors and other debtors in the timely and
orderly payment of their dues.
The strategic investor is, usually, put in charge of the
following:
Project Planning and Project Management

The strategic investor is uniquely positioned to plan the
technical side of the project and to implement it. He is,
therefore, put in charge of:
1. The selection of infrastructure, equipment, raw
materials, industrial processes, etc.;
2. Negotiations and agreements with providers and
suppliers;
3. Minimizing the costs of infrastructure by
deploying proprietary components and planning;
4. The provision of corporate guarantees and letters
of comfort to suppliers;
5. The planning and erecting of the various sites,
structures, buildings, premises, factories, etc.;
6. The planning and implementation of line
connections, computer network connections,
protocols, solving issues of compatibility
(hardware and software, etc.);
7. Project planning, implementation and supervision.
Marketing and Sales
1. The presentation to the Board an annual plan of
sales and marketing including: market penetration
targets, profiles of potential social and economic
categories of clients, sales promotion methods,
advertising campaigns, image, public relations and
other media campaigns. The strategic investor also
implements these plans or supervises their
implementation.
2. The strategic investor is usually possessed of a

brandname recognized in many countries. It is the
market leaders in certain territories. It has been
providing goods and services to users for a long
period of time, reliably. This is an important asset,
which, if properly used, can attract users. The
enhancement of the brandname, its recognition and
market awareness, market penetration, cobranding, collaboration with other suppliers â&#x20AC;&#x201C; are
all the responsibilities of the strategic investor.
3. The dissemination of the product as a preferred
choice among vendors, distributors, individual
users and businesses in the territory.
4. Special events, sponsorships, collaboration with
businesses.
5. The planning and implementation of incentive
systems (e.g., points, vouchers).
6. The strategic investor usually organizes a
distribution and dealership network, a franchising
network, or a sales network (retail chains)
including: training, pricing, pecuniary and quality
supervision, network control, inventory and
accounting controls, advertising, local marketing
and sales promotion and other network
management functions.
7. The strategic investor is also in charge of "vision
thinking": new methods of operation, new
marketing ploys, new market niches, predicting
the future trends and market needs, market
analyses and research, etc.
The strategic investor typically brings to the firm valuable
experience in marketing and sales. It has numerous off the

shelf marketing plans and drawer sales promotion
campaigns. It developed software and personnel capable
of analysing any market into effective niches and of
creating the right media (image and PR), advertising and
sales promotion drives best suited for it. It has built large
databases with multi-year profiles of the purchasing
patterns and demographic data related to thousands of
clients in many countries. It owns libraries of material,
images, sounds, paper clippings, articles, PR and image
materials, and proprietary trademarks and brand names.
Above all, it accumulated years of marketing and sales
promotion ideas which crystallized into a new conception
of the business.
Technology
1. The planning and implementation of new
technological systems up to their fully operational
phase. The strategic partner's engineers are
available to plan, implement and supervise all the
stages of the technological side of the business.
2. The planning and implementation of a fully
operative computer system (hardware, software,
communication, intranet) to deal with all the
aspects of the structure and the operation of the
firm. The strategic investor puts at the disposal of
the firm proprietary software developed by it and
specifically tailored to the needs of companies
operating in the firm's market.
3. The encouragement of the development of inhouse, proprietary, technological solutions to the
needs of the firm, its clients and suppliers.
4. The planning and the execution of an integration

program with new technologies in the field, in
collaboration with other suppliers or market
technological leaders.
Education and Training
The strategic investor is responsible to train all the
personnel in the firm: operators, customer services,
distributors, vendors, sales personnel. The training is
conducted at its sole expense and includes tours of its
facilities abroad.
The entrepreneurs â&#x20AC;&#x201C; who sought to introduce the two
types of investors, in the first place â&#x20AC;&#x201C; are usually left with
the following functions:
Administration and Control
1. To structure the firm in an optimal manner, most
conducive to the conduct of its business and to
present the new structure for the Board's approval
within 30 days from the date of the GM's
appointment.
2. To run the day to day business of the firm.
3. To oversee the personnel of the firm and to resolve
all the personnel issues.
4. To secure the unobstructed flow of relevant
information and the protection of confidential
organization.
5. To represent the firm in its contacts,
representations and negotiations with other firms,
authorities, or persons.
This is why entrepreneurs find it very hard to cohabitate

with investors of any kind. Entrepreneurs are excellent at
identifying the needs of the market and at introducing
technological or service solutions to satisfy such needs.
But the very personality traits which qualify them to
become entrepreneurs – also hinder the future
development of their firms. Only the introduction of
outside investors can resolve the dilemma. Outside
investors are not emotionally involved. They may be less
visionary – but also more experienced.
They are more interested in business results than in
dreams. And – being well acquainted with entrepreneurs –
they insist on having unmitigated control of the business,
for fear of losing all their money. These things antagonize
the entrepreneurs. They feel that they are losing their
creation to cold-hearted, mean spirited, corporate
predators. They rebel and prefer to remain small or even
to close shop than to give up their cherished freedoms.
This is where nine out of ten entrepreneurs fail - in
knowing when to let go.
Return

The Myth of the Earnings Yield
In American novels, well into the 1950's, one finds
protagonists using the future stream of dividends
emanating from their share holdings to send their kids to
college or as collateral. Yet, dividends seemed to have
gone the way of the Hula-Hoop. Few companies distribute
erratic and ever-declining dividends. The vast majority
don't bother. The unfavorable tax treatment of distributed
profits may have been the cause.
The dwindling of dividends has implications which are
nothing short of revolutionary. Most of the financial
theories we use to determine the value of shares were
developed in the 1950's and 1960's, when dividends were
in vogue. They invariably relied on a few implicit and
explicit assumptions:
1. That the fair "value" of a share is closely
correlated to its market price;
2. That price movements are mostly random, though
somehow related to the aforementioned "value" of
the share. In other words, the price of a security is
supposed to converge with its fair "value" in the
long term;
3. That the fair value responds to new information
about the firm and reflects it - though how
efficiently is debatable. The strong efficiency
market hypothesis assumes that new information is
fully incorporated in prices instantaneously.

But how is the fair value to be determined?
A discount rate is applied to the stream of all future
income from the share - i.e., its dividends. What should
this rate be is sometimes hotly disputed - but usually it is
the coupon of "riskless" securities, such as treasury bonds.
But since few companies distribute dividends theoreticians and analysts are increasingly forced to deal
with "expected" dividends rather than "paid out" or actual
ones.
The best proxy for expected dividends is net earnings. The
higher the earnings - the likelier and the higher the
dividends. Thus, in a subtle cognitive dissonance, retained
earnings - often plundered by rapacious managers - came
to be regarded as some kind of deferred dividends.
The rationale is that retained earnings, once re-invested,
generate additional earnings. Such a virtuous cycle
increases the likelihood and size of future dividends. Even
undistributed earnings, goes the refrain, provide a rate of
return, or a yield - known as the earnings yield. The
original meaning of the word "yield" - income realized by
an investor - was undermined by this Newspeak.
Why was this oxymoron - the "earnings yield" perpetuated?
According to all current theories of finance, in the absence
of dividends - shares are worthless. The value of an
investor's holdings is determined by the income he stands
to receive from them. No income - no value. Of course, an
investor can always sell his holdings to other investors
and realize capital gains (or losses). But capital gains though also driven by earnings hype - do not feature in
financial models of stock valuation.

Faced with a dearth of dividends, market participants and especially Wall Street firms - could obviously not live
with the ensuing zero valuation of securities. They
resorted to substituting future dividends - the outcome of
capital accumulation and re-investment - for present ones.
The myth was born.
Thus, financial market theories starkly contrast with
market realities.
No one buys shares because he expects to collect an
uninterrupted and equiponderant stream of future income
in the form of dividends. Even the most gullible novice
knows that dividends are a mere apologue, a relic of the
past. So why do investors buy shares? Because they hope
to sell them to other investors later at a higher price.
While past investors looked to dividends to realize income
from their shareholdings - present investors are more into
capital gains. The market price of a share reflects its
discounted expected capital gains, the discount rate being
its volatility. It has little to do with its discounted future
stream of dividends, as current financial theories teach us.
But, if so, why the volatility in share prices, i.e., why are
share prices distributed? Surely, since, in liquid markets,
there are always buyers - the price should stabilize around
an equilibrium point.
It would seem that share prices incorporate expectations
regarding the availability of willing and able buyers, i.e.,
of investors with sufficient liquidity. Such expectations
are influenced by the price level - it is more difficult to
find buyers at higher prices - by the general market
sentiment, and by externalities and new information,
including new information about earnings.

The capital gain anticipated by a rational investor takes
into consideration both the expected discounted earnings
of the firm and market volatility - the latter being a
measure of the expected distribution of willing and able
buyers at any given price. Still, if earnings are retained
and not transmitted to the investor as dividends - why
should they affect the price of the share, i.e., why should
they alter the capital gain?
Earnings serve merely as a yardstick, a calibrator, a
benchmark figure. Capital gains are, by definition, an
increase in the market price of a security. Such an increase
is more often than not correlated with the future stream of
income to the firm - though not necessarily to the
shareholder. Correlation does not always imply causation.
Stronger earnings may not be the cause of the increase in
the share price and the resulting capital gain. But
whatever the relationship, there is no doubt that earnings
are a good proxy to capital gains.
Hence investors' obsession with earnings figures. Higher
earnings rarely translate into higher dividends. But
earnings - if not fiddled - are an excellent predictor of the
future value of the firm and, thus, of expected capital
gains. Higher earnings and a higher market valuation of
the firm make investors more willing to purchase the
stock at a higher price - i.e., to pay a premium which
translates into capital gains.
The fundamental determinant of future income from share
holding was replaced by the expected value of shareownership. It is a shift from an efficient market - where all
new information is instantaneously available to all rational
investors and is immediately incorporated in the price of
the share - to an inefficient market where the most critical
information is elusive: how many investors are willing

and able to buy the share at a given price at a given
moment.
A market driven by streams of income from holding
securities is "open". It reacts efficiently to new
information. But it is also "closed" because it is a zero
sum game. One investor's gain is another's loss. The
distribution of gains and losses in the long term is pretty
even, i.e., random. The price level revolves around an
anchor, supposedly the fair value.
A market driven by expected capital gains is also "open"
in a way because, much like less reputable pyramid
schemes, it depends on new capital and new investors. As
long as new money keeps pouring in, capital gains
expectations are maintained - though not necessarily
realized.
But the amount of new money is finite and, in this sense,
this kind of market is essentially a "closed" one. When
sources of funding are exhausted, the bubble bursts and
prices decline precipitously. This is commonly described
as an "asset bubble".
This is why current investment portfolio models (like
CAPM) are unlikely to work. Both shares and markets
move in tandem (contagion) because they are exclusively
swayed by the availability of future buyers at given prices.
This renders diversification inefficacious. As long as
considerations of "expected liquidity" do not constitute an
explicit part of income-based models, the market will
render them increasingly irrelevant.

Return

Technical vs. Fundamental Analysis of Stocks
The authors of a paper published by NBER on March
2000 and titled "The Foundations of Technical Analysis" Andrew Lo, Harry Mamaysky, and Jiang Wang - claim
that:
"Technical analysis, also known as 'charting', has been
part of financial practice for many decades, but this
discipline has not received the same level of academic
scrutiny and acceptance as more traditional approaches
such as fundamental analysis.
One of the main obstacles is the highly subjective nature
of technical analysis - the presence of geometric shapes in
historical price charts is often in the eyes of the beholder.
In this paper we offer a systematic and automatic
approach to technical pattern recognition ... and apply the
method to a large number of US stocks from 1962 to
1996..."
And the conclusion:
" ... Over the 31-year sample period, several technical
indicators do provide incremental information and may
have some practical value."

These hopeful inferences are supported by the work of
other scholars, such as Paul Weller of the Finance
Department of the university of Iowa. While he admits the
limitations of technical analysis - it is a-theoretic and data
intensive, pattern over-fitting can be a problem, its rules
are often difficult to interpret, and the statistical testing is
cumbersome - he insists that "trading rules are picking up
patterns in the data not accounted for by standard
statistical models" and that the excess returns thus
generated are not simply a risk premium.
Technical analysts have flourished and waned in line with
the stock exchange bubble. They and their multi-colored
charts regularly graced CNBC, the CNN and other
market-driving channels. "The Economist" found that
many successful fund managers have regularly resorted to
technical analysis - including George Soros' Quantum
Hedge fund and Fidelity's Magellan. Technical analysis
may experience a revival now that corporate accounts the fundament of fundamental analysis - have been
rendered moot by seemingly inexhaustible scandals.
The field is the progeny of Charles Dow of Dow Jones
fame and the founder of the "Wall Street Journal". He
devised a method to discern cyclical patterns in share
prices. Other sages - such as Elliott - put forth complex
"wave theories". Technical analysts now regularly employ
dozens of geometric configurations in their divinations.
Technical analysis is defined thus in "The Econometrics
of Financial Markets", a 1997 textbook authored by John
Campbell, Andrew Lo, and Craig MacKinlay:
"An approach to investment management based on the
belief that historical price series, trading volume, and
other market statistics exhibit regularities - often ... in the

form of geometric patterns ... that can be profitably
exploited to extrapolate future price movements."
A less fanciful definition may be the one offered by
Edwards and Magee in "Technical Analysis of Stock
Trends":
"The science of recording, usually in graphic form, the
actual history of trading (price changes, volume of
transactions, etc.) in a certain stock or in 'the averages' and
then deducing from that pictured history the probable
future trend."
Fundamental analysis is about the study of key statistics
from the financial statements of firms as well as
background information about the company's products,
business plan, management, industry, the economy, and
the marketplace.
Economists, since the 1960's, sought to rebuff technical
analysis. Markets, they say, are efficient and "walk"
randomly. Prices reflect all the information known to
market players - including all the information pertaining
to the future. Technical analysis has often been compared
to voodoo, alchemy, and astrology - for instance by
Burton Malkiel in his seminal work, "A Random Walk
Down Wall Street".
The paradox is that technicians are more orthodox than
the most devout academic. They adhere to the strong
version of market efficiency. The market is so efficient,
they say, that nothing can be gleaned from fundamental
analysis. All fundamental insights, information, and
analyses are already reflected in the price. This is why one
can deduce future prices from past and present ones.
Jack Schwager, sums it up in his book "Schwager on

Futures: Technical Analysis", quoted by Stockcharts.com:
"One way of viewing it is that markets may witness
extended periods of random fluctuation, interspersed with
shorter periods of nonrandom behavior. The goal of the
chartist is to identify those periods (i.e. major trends)."
Not so, retort the fundamentalists. The fair value of a
security or a market can be derived from available
information using mathematical models - but is rarely
reflected in prices. This is the weak version of the market
efficiency hypothesis.
The mathematically convenient idealization of the
efficient market, though, has been debunked in numerous
studies. These are efficiently summarized in Craig
McKinlay and Andrew Lo's tome "A Non-random Walk
Down Wall Street" published in 1999.
Not all markets are strongly efficient. Most of them sport
weak or "semi-strong" efficiency. In some markets, a filter
model - one that dictates the timing of sales and purchases
- could prove useful. This is especially true when the
equilibrium price of a share - or of the market as a whole changes as a result of externalities.
Substantive news, change in management, an oil shock, a
terrorist attack, an accounting scandal, an FDA approval, a
major contract, or a natural, or man-made disaster - all
cause share prices and market indices to break the
boundaries of the price band that they have occupied.
Technical analysts identify these boundaries and trace
breakthroughs and their outcomes in terms of prices.
Technical analysis may be nothing more than a selffulfilling prophecy, though. The more devotees it has, the
stronger it affects the shares or markets it analyses.

Investors move in herds and are inclined to seek patterns
in the often bewildering marketplace. As opposed to the
assumptions underlying the classic theory of portfolio
analysis - investors do remember past prices. They
hesitate before they cross certain numerical thresholds.
But this herd mentality is also the Achilles heel of
technical analysis. If everyone were to follow its guidance
- it would have been rendered useless. If everyone were to
buy and sell at the same time - based on the same
technical advice - price advantages would have been
arbitraged away instantaneously. Technical analysis is
about privileged information to the privileged few though not too few, lest prices are not swayed.
Studies cited in Edwin Elton and Martin Gruber's
"Modern Portfolio Theory and Investment Analysis" and
elsewhere show that a filter model - trading with technical
analysis - is preferable to a "buy and hold" strategy but
inferior to trading at random. Trading against
recommendations issued by a technical analysis model
and with them - yielded the same results. Fama-Blum
discovered that the advantage proffered by such models is
identical to transaction costs.
The proponents of technical analysis claim that rather than
forming investor psychology - it reflects their risk
aversion at different price levels. Moreover, the borders
between the two forms of analysis - technical and
fundamental - are less sharply demarcated nowadays.
"Fundamentalists" insert past prices and volume data in
their models - and "technicians" incorporate arcana such
as the dividend stream and past earnings in theirs.
It is not clear why should fundamental analysis be
considered superior to its technical alternative. If prices

incorporate all the information known and reflect it predicting future prices would be impossible regardless of
the method employed. Conversely, if prices do not reflect
all the information available, then surely investor
psychology is as important a factor as the firm's - now oftdiscredited - financial statements?
Prices, after all, are the outcome of numerous interactions
among market participants, their greed, fears, hopes,
expectations, and risk aversion. Surely studying this
emotional and cognitive landscape is as crucial as figuring
the effects of cuts in interest rates or a change of CEO?
Still, even if we accept the rigorous version of market
efficiency - i.e., as Aswath Damodaran of the Stern
Business School at NYU puts it, that market prices are
"unbiased estimates of the true value of investments" prices do react to new information - and, more
importantly, to anticipated information. It takes them time
to do so. Their reaction constitutes a trend and identifying
this trend at its inception can generate excess yields. On
this both fundamental and technical analysis are agreed.
Moreover, markets often over-react: they undershoot or
overshoot the "true and fair value". Fundamental analysis
calls this oversold and overbought markets. The correction
back to equilibrium prices sometimes takes years. A savvy
trader can profit from such market failures and excesses.
As quality information becomes ubiquitous and
instantaneous, research issued by investment banks
discredited, privileged access to information by analysts
prohibited, derivatives proliferate, individual participation
in the stock market increases, and transaction costs turn
negligible - a major rethink of our antiquated financial
models is called for.

The maverick Andrew Lo, a professor of finance at the
Sloan School of Management at MIT, summed up the lure
of technical analysis in lyric terms in an interview he gave
to Traders.com's "Technical Analysis of Stocks and
Commodities", quoted by Arthur Hill in Stockcharts.com:
"The more creativity you bring to the investment process,
the more rewarding it will be. The only way to maintain
ongoing success, however, is to constantly innovate.
That's much the same in all endeavors. The only way to
continue making money, to continue growing and keeping
your profit margins healthy, is to constantly come up with
new ideas."

Also Read:
The Myth of the Earnings Yield
Models of Stock Valuation
Portfolio Management Theory and Technical Analysis
Lecture Notes

Return

Volatility and Risk
Volatility is considered the most accurate measure of risk
and, by extension, of return, its flip side. The higher the
volatility, the higher the risk - and the reward. That
volatility increases in the transition from bull to bear
markets seems to support this pet theory. But how to
account for surging volatility in plummeting bourses? At
the depths of the bear phase, volatility and risk increase
while returns evaporate - even taking short-selling into
account.
"The Economist" has recently proposed yet another
dimension of risk:
"The Chicago Board Options Exchange's VIX index, a
measure of traders' expectations of share price gyrations,
in July reached levels not seen since the 1987 crash, and
shot up again (two weeks ago)... Over the past five years,
volatility spikes have become ever more frequent, from
the Asian crisis in 1997 right up to the World Trade Centre
attacks. Moreover, it is not just price gyrations that have
increased, but the volatility of volatility itself. The
markets, it seems, now have an added dimension of risk."
Call-writing has soared as punters, fund managers, and
institutional investors try to eke an extra return out of the
wild ride and to protect their dwindling equity portfolios.
Naked strategies - selling options contracts or buying
them in the absence of an investment portfolio of
underlying assets - translate into the trading of volatility
itself and, hence, of risk. Short-selling and spread-betting

funds join single stock futures in profiting from the
downside.
Market - also known as beta or systematic - risk and
volatility reflect underlying problems with the economy as
a whole and with corporate governance: lack of
transparency, bad loans, default rates, uncertainty,
illiquidity, external shocks, and other negative
externalities. The behavior of a specific security reveals
additional, idiosyncratic, risks, known as alpha.
Quantifying volatility has yielded an equal number of
Nobel prizes and controversies. The vacillation of security
prices is often measured by a coefficient of variation
within the Black-Scholes formula published in 1973.
Volatility is implicitly defined as the standard deviation of
the yield of an asset. The value of an option increases with
volatility. The higher the volatility the greater the option's
chance during its life to be "in the money" - convertible to
the underlying asset at a handsome profit.
Without delving too deeply into the model, this
mathematical expression works well during trends and
fails miserably when the markets change sign. There is
disagreement among scholars and traders whether one
should better use historical data or current market prices which include expectations - to estimate volatility and to
price options correctly.
From "The Econometrics of Financial Markets" by John
Campbell, Andrew Lo, and Craig MacKinlay, Princeton
University Press, 1997:
"Consider the argument that implied volatilities are better
forecasts of future volatility because changing market
conditions cause volatilities (to) vary through time

stochastically, and historical volatilities cannot adjust to
changing market conditions as rapidly. The folly of this
argument lies in the fact that stochastic volatility
contradicts the assumption required by the B-S model - if
volatilities do change stochastically through time, the
Black-Scholes formula is no longer the correct pricing
formula and an implied volatility derived from the BlackScholes formula provides no new information."
Black-Scholes is thought deficient on other issues as well.
The implied volatilities of different options on the same
stock tend to vary, defying the formula's postulate that a
single stock can be associated with only one value of
implied volatility. The model assumes a certain geometric Brownian - distribution of stock prices that has
been shown to not apply to US markets, among others.
Studies have exposed serious departures from the price
process fundamental to Black-Scholes: skewness, excess
kurtosis (i.e., concentration of prices around the mean),
serial correlation, and time varying volatilities. BlackScholes tackles stochastic volatility poorly. The formula
also unrealistically assumes that the market dickers
continuously, ignoring transaction costs and institutional
constraints. No wonder that traders use Black-Scholes as a
heuristic rather than a price-setting formula.
Volatility also decreases in administered markets and over
different spans of time. As opposed to the received
wisdom of the random walk model, most investment
vehicles sport different volatilities over different time
horizons. Volatility is especially high when both supply
and demand are inelastic and liable to large, random
shocks. This is why the prices of industrial goods are less
volatile than the prices of shares, or commodities.

But why are stocks and exchange rates volatile to start
with? Why don't they follow a smooth evolutionary path
in line, say, with inflation, or interest rates, or
productivity, or net earnings?
To start with, because economic fundamentals fluctuate sometimes as wildly as shares. The Fed has cut interest
rates 11 times in the past 12 months down to 1.75 percent
- the lowest level in 40 years. Inflation gyrated from
double digits to a single digit in the space of two decades.
This uncertainty is, inevitably, incorporated in the price
signal.
Moreover, because of time lags in the dissemination of
data and its assimilation in the prevailing operational
model of the economy - prices tend to overshoot both
ways. The economist Rudiger Dornbusch, who died last
month, studied in his seminal paper, "Expectations and
Exchange Rate Dynamics", published in 1975, the
apparently irrational ebb and flow of floating currencies.
His conclusion was that markets overshoot in response to
surprising changes in economic variables. A sudden
increase in the money supply, for instance, axes interest
rates and causes the currency to depreciate. The rational
outcome should have been a panic sale of obligations
denominated in the collapsing currency. But the
devaluation is so excessive that people reasonably expect
a rebound - i.e., an appreciation of the currency - and
purchase bonds rather than dispose of them.
Yet, even Dornbusch ignored the fact that some price
twirls have nothing to do with economic policies or
realities, or with the emergence of new information - and
a lot to do with mass psychology. How else can we
account for the crash of October 1987? This goes to the

heart of the undecided debate between technical and
fundamental analysts.
As Robert Shiller has demonstrated in his tomes "Market
Volatility" and "Irrational Exuberance", the volatility of
stock prices exceeds the predictions yielded by any
efficient market hypothesis, or by discounted streams of
future dividends, or earnings. Yet, this finding is hotly
disputed.
Some scholarly studies of researchers such as Stephen
LeRoy and Richard Porter offer support - other, no less
weighty, scholarship by the likes of Eugene Fama,
Kenneth French, James Poterba, Allan Kleidon, and
William Schwert negate it - mainly by attacking Shiller's
underlying assumptions and simplifications. Everyone opponents and proponents alike - admit that stock returns
do change with time, though for different reasons.
Volatility is a form of market inefficiency. It is a reaction
to incomplete information (i.e., uncertainty). Excessive
volatility is irrational. The confluence of mass greed, mass
fears, and mass disagreement as to the preferred mode of
reaction to public and private information - yields price
fluctuations.
Changes in volatility - as manifested in options and
futures premiums - are good predictors of shifts in
sentiment and the inception of new trends. Some traders
are contrarians. When the VIX or the NASDAQ Volatility
indices are high - signifying an oversold market - they buy
and when the indices are low, they sell.
Chaikin's Volatility Indicator, a popular timing tool, seems
to couple market tops with increased indecisiveness and
nervousness, i.e., with enhanced volatility. Market

bottoms - boring, cyclical, affairs - usually suppress
volatility. Interestingly, Chaikin himself disputes this
interpretation. He believes that volatility increases near
the bottom, reflecting panic selling - and decreases near
the top, when investors are in full accord as to market
direction.
But most market players follow the trend. They sell when
the VIX is high and, thus, portends a declining market. A
bullish consensus is indicated by low volatility. Thus, low
VIX readings signal the time to buy. Whether this is more
than superstition or a mere gut reaction remains to be
seen.
It is the work of theoreticians of finance. Alas, they are
consumed by mutual rubbishing and dogmatic thinking.
The few that wander out of the ivory tower and actually
bother to ask economic players what they think and do and why - are much derided. It is a dismal scene, devoid
of volatile creativity.
A Note on Short Selling and Volatility
Short selling involves the sale of securities borrowed from
brokers who, in turn, usually borrow them from third
party investors. The short seller pays a negotiated fee for
the privilege and has to "cover" her position: to re-acquire
the securities she had sold and return them to the lender
(again via the broker). This allows her to bet on the
decline of stocks she deems overvalued and to benefit if
she is proven right: she sells the securities at a high price
and re-acquires them once their prices have, indeed,
tanked.
A study titled "A Close Look at Short Selling on
NASDAQ", authored by James Angel of Georgetown

University - Department of Finance and Stephen E.
Christophe and Michael G. Ferri of George Mason
University - School of Management, and published in the
Financial Analysts Journal, Vol. 59, No. 6, pp. 66-74,
November/December 2003, yielded some surprising
findings:
"(1) overall, 1 of every 42 trades involves a short sale;
(2) short selling is more common among stocks with
high returns than stocks with weaker performance; (3)
actively traded stocks experience more short sales than
stocks of limited trading volume; (4) short selling varies
directly with share price volatility; (5) short selling does
not appear to be systematically different on various days
of the week; and (6) days of high short selling precede
days of unusually low returns."
Many economists insist that short selling is a mechanism
which stabilizes stock markets, reduces volatility, and
creates
incentives to correctly price securities. This sentiment is
increasingly more common even among hitherto skeptical
economists in developing countries.
In an interview he granted to Financialexpress.com in
January 2007, Marti G Subrahmanyam, the Indian-born
Charles E Merrill professor of Finance and Economics in
the Stern School of Business at New York University had
this to say:
"Q: Should short-selling be allowed?
A: Such kind of restrictions would only magnify the
volatility and crisis. If a person who is bearish on the
market and is not allowed to short sell, the market
cannot discount the true sentiment and when more and

more negative information pour in, the market suddenly
slips down heavily."
But not everyone agrees. In a paper titled "The Impact of
Short Selling on the Price-Volume Relationship:
Evidence from Hong Kong", the authors, Michael D.
McKenzie or RMIT University - School of Economics
and Finance and Olan T. Henry of the University of
Melbourne - Department of Economics, unequivocally
state:
"The results suggest (i) that the market displays greater
volatility following a period of short selling and (ii) that
asymmetric responses to positive and negative
innovations to returns appear to be exacerbated by short
selling."
Similar evidence emerged from Australia. In a paper titled
"Short Sales Are Almost Instantaneously Bad News:
Evidence from the Australian Stock Exchange", the
authors, Michael J. Aitken, Alex Frino, Michael S.
McCorry, and Peter L. Swan of the University of Sydney
and Barclays Global Investors, investigated "the market
reaction to short sales on an intraday basis in a market
setting where short sales are transparent immediately
following execution."
They found "a mean reassessment of stock value
following short sales of up to â&#x2C6;&#x2019;0.20 percent with adverse
information impounded within fifteen minutes or twenty
trades. Short sales executed near the end of the
financial year and those related to arbitrage and
hedging activities are associated with a smaller price
reaction; trades near information events precipitate
larger price reactions. The evidence is generally weaker
for short sales executed using limit orders relative to

market orders." Transparent short sales, in other words,
increase the volatility of shorted stocks.
Studies of the German DAX, conducted in 1996-8 by
Alexander Kempf, Chairman of the Departments of
Finance in the University of Cologne and, subsequently, at
the University of Mannheim, found that mispricing of
stocks increases with the introduction of arbitrage trading
techniques. "Overall, the empirical evidence suggests
that short selling restrictions and early unwinding
opportunities are very influential factors for the
behavior of the mispricing." - Concluded the author.
Charles M. Jones and Owen A. Lamont, who studied the
1926-33 bubble in the USA, flatly state: "Stocks can be
overpriced when short sale constraints bind." (NBER
Working Paper No. 8494, issued in October 2001).
Similarly, in a January 2006 study titled "The Effect of
Short Sales Constraints on SEO Pricing", the authors,
Charlie Charoenwong and David K. Ding of the Ping
Wang Division of Banking and Finance at the Nanyang
Business School of the Nanyang Technological University
Singapore, summarized by saying:
"The (short selling) Ruleâ&#x20AC;&#x2122;s restrictions on informed
trading appear to cause overpricing of stocks for which
traders have access to private adverse information,
which increases the pressure to sell on the offer day."
In a March 2004 paper titled "Options and the Bubble",
Robert H. Battalio and Paul H. Schultz of University of
Notre Dame - Department of Finance and Business
Economics contradict earlier (2003) findings by Ofek and
Richardson and correctly note:
"Many believe that a bubble was behind the high prices

of Internet stocks in 1999-2000, and that short-sale
restrictions prevented rational investors from driving
Internet stock prices to reasonable levels. Using intraday
options data from the peak of the Internet bubble, we
find no evidence that short-sale restrictions affected
Internet stock prices. Investors could also cheaply short
synthetically using options. Option strategies could also
permit investors to mitigate synchronization risk. During
this time, information was discovered in the options
market and transmitted to the stock market, suggesting
that the bubble could have been burst by options
trading."
But these findings, of course, would not apply to markets
with non-efficient, illiquid, or non-existent options
exchanges - in short, they are inapplicable to the vast
majority of stock exchanges, even in the USA.
A much larger study, based on data from 111 countries
with a stock exchange market was published in December
2003. Titled "The World Price of Short Selling" and
written by Anchada Charoenrook of Vanderbilt
University - Owen Graduate School of Management and
Hazem Daouk of Cornell University - Department of
Applied Economics and Management, its conclusions are
equally emphatic:
"We find that there is no difference in the level of
skewness and coskewness of returns, probability of a
crash occurring, or the frequency of crashes, when
short-selling is possible and when it is not. When shortselling is possible, volatility of aggregate stock returns is
lower. When short-selling is possible, liquidity is higher
consistent with predictions by Diamond and Verrecchia
(1987). Lastly, we find that when countries change from
a regime where short-selling is not possible to where it is

possible, the stock price increases implying that the cost
of capital is lower. Collectively, the empirical evidence
suggests that short-sale constraints reduce market
quality."
But the picture may not be as uniform as this study
implies.
Within the framework of Regulation SHO, a revamp of
short sales rules effected in 2004, the US Securities and
Exchange Commission (SEC) lifted, in May 2005, all
restrictions on the short selling of 1000 stocks. In
September 2006, according to Associated Press, many of
its economists (though not all of them) concluded that:
"Order routing, short-selling mechanics and intraday
market volatility has been affected by the experiment,
with volatility increasing for smaller stocks and
declining for larger stocks. Market quality and liquidity
don't appear to have been harmed."
Subsequently, the aforementioned conclusions
notwithstanding, the SEC recommended to remove all
restrictions on stocks of all sizes and to incorporate this
mini-revolution in its July 2007 regulation NMS for
broker-dealers. Short selling seems to have finally hit the
mainstream.
Volatility and Price Discovery
Three of the most important functions of free markets are:
price discovery, the provision of liquidity, and capital
allocation. Honest and transparent dealings between
willing buyers and sellers are thought to result in liquid
and efficient marketplaces. Prices are determined, second
by second, in a process of public negotiation, taking old
and emergent information about risks and returns into

account. Capital is allocated to the highest bidder, who,
presumably, can make the most profit on it. And every
seller finds a buyer and vice versa.
The current global crisis is not only about the failure of a
few investment banks (in the USA) and retail banks (in
Europe). The very concept of free markets seems to have
gone bankrupt. This was implicitly acknowledged by
governments as they rushed to nationalize banks and
entire financial systems.
In the last 14 months (August 2007 to October 2008),
markets repeatedly failed to price assets correctly. From
commodities to stocks, from derivatives to houses, and
from currencies to art prices gyrate erratically and
irrationally all over the charts. The markets are helpless
and profoundly dysfunctional: no one seems to know what
is the "correct" price for oil, shares, housing, gold, or
anything else for that matter. Disagreements between
buyers and sellers regarding the "right" prices are so
unbridgeable and so frequent that price volatility (as
measured, for instance, by the VIX index) has increased to
an all time high. Speculators have benefited from
unprecedented opportunities for arbitrage. Mathematicaleconomic models of risk, diversification, portfolio
management and insurance have proven to be useless.
Inevitably, liquidity has dried up. Entire markets vanished
literally overnight: collateralized debt obligations and
swaps (CDOs and CDSs), munis (municipal bonds),
commercial paper, mortgage derivatives, interbank
lending. Attempts by central banks to inject liquidity into
a moribund system have largely floundered and proved
futile.
Finally, markets have consistently failed to allocate capital

efficiently and to put it to the most-profitable use. In the
last decade or so, business firms (mainly in the USA) have
destroyed more economic value than they have created.
This net destruction of assets, both tangible and
intangible, retarded wealth formation. In some respects,
the West - and especially the United States - are poorer
now than they were in 1988. This monumental waste of
capital was a result of the policies of free and easy money
adopted by the world's central banks since 2001. Easy
come, easy go, I guess.

Return

The Bursting Asset Bubbles
I. Overview
Also published by United Press International (UPI)
The recent implosion of the global equity markets - from
Hong Kong to New York - engendered yet another round
of the semipternal debate: should central banks
contemplate abrupt adjustments in the prices of assets such as stocks or real estate - as they do changes in the
consumer price indices? Are asset bubbles indeed
inflationary and their bursting deflationary?
Central bankers counter that it is hard to tell a bubble until
it bursts and that market intervention bring about that
which it is intended to prevent. There is insufficient
historical data, they reprimand errant scholars who insist
otherwise. This is disingenuous. Ponzi and pyramid
schemes have been a fixture of Western civilization at
least since the middle Renaissance.
Assets tend to accumulate in "asset stocks". Residences
built in the 19th century still serve their purpose today.
The quantity of new assets created at any given period is,
inevitably, negligible compared to the stock of the same
class of assets accumulated over decades and, sometimes,
centuries. This is why the prices of assets are not anchored
- they are only loosely connected to their production costs
or even to their replacement value.
Asset bubbles are not the exclusive domain of stock
exchanges and shares. "Real" assets include land and the
property built on it, machinery, and other tangibles.

"Financial" assets include anything that stores value and
can serve as means of exchange - from cash to securities.
Even tulip bulbs will do.
In 1634, in what later came to be known as "tulipmania",
tulip bulbs were traded in a special marketplace in
Amsterdam, the scene of a rabid speculative frenzy. Some
rare black tulip bulbs changed hands for the price of a big
mansion house. For four feverish years it seemed like the
craze would last forever. But the bubble burst in 1637. In
a matter of a few days, the price of tulip bulbs was slashed
by 96%!
Uniquely, tulipmania was not an organized scam with an
identifiable group of movers and shakers, which
controlled and directed it. Nor has anyone made explicit
promises to investors regarding guaranteed future profits.
The hysteria was evenly distributed and fed on itself.
Subsequent investment fiddles were different, though.
Modern dodges entangle a large number of victims. Their
size and all-pervasiveness sometimes threaten the national
economy and the very fabric of society and incur grave
political and social costs.
There are two types of bubbles.
Asset bubbles of the first type are run or fanned by
financial intermediaries such as banks or brokerage
houses. They consist of "pumping" the price of an asset or
an asset class. The assets concerned can be shares,
currencies, other securities and financial instruments - or
even savings accounts. To promise unearthly yields on
one's savings is to artificially inflate the "price", or the
"value" of one's savings account.
More than one fifth of the population of 1983 Israel were

involved in a banking scandal of Albanian proportions. It
was a classic pyramid scheme. All the banks, bar one,
promised to gullible investors ever increasing returns on
the banks' own publicly-traded shares.
These explicit and incredible promises were included in
prospectuses of the banks' public offerings and won the
implicit acquiescence and collaboration of successive
Israeli governments. The banks used deposits, their
capital, retained earnings and funds illegally borrowed
through shady offshore subsidiaries to try to keep their
impossible and unhealthy promises. Everyone knew what
was going on and everyone was involved. It lasted 7
years. The prices of some shares increased by 1-2 percent
daily.
On October 6, 1983, the entire banking sector of Israel
crumbled. Faced with ominously mounting civil unrest,
the government was forced to compensate shareholders. It
offered them an elaborate share buyback plan over 9
years. The cost of this plan was pegged at $6 billion almost 15 percent of Israel's annual GDP. The indirect
damage remains unknown.
Avaricious and susceptible investors are lured into
investment swindles by the promise of impossibly high
profits or interest payments. The organizers use the money
entrusted to them by new investors to pay off the old ones
and thus establish a credible reputation. Charles Ponzi
perpetrated many such schemes in 1919-1925 in Boston
and later the Florida real estate market in the USA. Hence
a "Ponzi scheme".
In Macedonia, a savings bank named TAT collapsed in
1997, erasing the economy of an entire major city, Bitola.
After much wrangling and recriminations - many

politicians seem to have benefited from the scam - the
government, faced with elections in September, has
recently decided, in defiance of IMF diktats, to offer
meager compensation to the afflicted savers. TAT was
only one of a few similar cases. Similar scandals took
place in Russia and Bulgaria in the 1990's.
One third of the impoverished population of Albania was
cast into destitution by the collapse of a series of nationwide leveraged investment plans in 1997. Inept political
and financial crisis management led Albania to the verge
of disintegration and a civil war. Rioters invaded police
stations and army barracks and expropriated hundreds of
thousands of weapons.
Islam forbids its adherents to charge interest on money
lent - as does Judaism. To circumvent this onerous decree,
entrepreneurs and religious figures in Egypt and in
Pakistan established "Islamic banks". These institutions
pay no interest on deposits, nor do they demand interest
from borrowers. Instead, depositors are made partners in
the banks' - largely fictitious - profits. Clients are charged
for - no less fictitious - losses. A few Islamic banks were
in the habit of offering vertiginously high "profits". They
went the way of other, less pious, pyramid schemes. They
melted down and dragged economies and political
establishments with them.
By definition, pyramid schemes are doomed to failure.
The number of new "investors" - and the new money they
make available to the pyramid's organizers - is limited.
When the funds run out and the old investors can no
longer be paid, panic ensues. In a classic "run on the
bank", everyone attempts to draw his money
simultaneously. Even healthy banks - a distant relative of
pyramid schemes - cannot cope with such stampedes.

Some of the money is invested long-term, or lent. Few
financial institutions keep more than 10 percent of their
deposits in liquid on-call reserves.
Studies repeatedly demonstrated that investors in pyramid
schemes realize their dubious nature and stand forewarned
by the collapse of other contemporaneous scams. But they
are swayed by recurrent promises that they could draw
their money at will ("liquidity") and, in the meantime,
receive alluring returns on it ("capital gains", "interest
payments", "profits").
People know that they are likelier to lose all or part of
their money as time passes. But they convince themselves
that they can outwit the organizers of the pyramid, that
their withdrawals of profits or interest payments prior to
the inevitable collapse will more than amply compensate
them for the loss of their money. Many believe that they
will succeed to accurately time the extraction of their
original investment based on - mostly useless and
superstitious - "warning signs".
While the speculative rash lasts, a host of pundits,
analysts, and scholars aim to justify it. The "new
economy" is exempt from "old rules and archaic modes of
thinking". Productivity has surged and established a
steeper, but sustainable, trend line. Information
technology is as revolutionary as electricity. No, more
than electricity. Stock valuations are reasonable. The Dow
is on its way to 33,000. People want to believe these
"objective, disinterested analyses" from "experts".
Investments by households are only one of the engines of
this first kind of asset bubbles. A lot of the money that
pours into pyramid schemes and stock exchange booms is
laundered, the fruits of illicit pursuits. The laundering of

tax-evaded money or the proceeds of criminal activities,
mainly drugs, is effected through regular banking
channels. The money changes ownership a few times to
obscure its trail and the identities of the true owners.
Many offshore banks manage shady investment ploys.
They maintain two sets of books. The "public" or
"cooked" set is made available to the authorities - the tax
administration, bank supervision, deposit insurance, law
enforcement agencies, and securities and exchange
commission. The true record is kept in the second,
inaccessible, set of files.
This second set of accounts reflects reality: who deposited
how much, when and subject to which conditions - and
who borrowed what, when and subject to what terms.
These arrangements are so stealthy and convoluted that
sometimes even the shareholders of the bank lose track of
its activities and misapprehend its real situation.
Unscrupulous management and staff sometimes take
advantage of the situation. Embezzlement, abuse of
authority, mysterious trades, misuse of funds are more
widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and
Commerce International (BCCI) in London in 1991
revealed that, for the better part of a decade, the
executives and employees of this penumbral institution
were busy stealing and misappropriating $10 billion. The
Bank of England's supervision department failed to spot
the rot on time. Depositors were - partially - compensated
by the main shareholder of the bank, an Arab sheikh. The
story repeated itself with Nick Leeson and his
unauthorized disastrous trades which brought down the
venerable and veteran Barings Bank in 1995.

The combination of black money, shoddy financial
controls, shady bank accounts and shredded documents
renders a true account of the cash flows and damages in
such cases all but impossible. There is no telling what
were the contributions of drug barons, American off-shore
corporations, or European and Japanese tax-evaders channeled precisely through such institutions - to the
stratospheric rise in Wall-Street in the last few years.
But there is another - potentially the most pernicious type of asset bubble. When financial institutions lend to
the unworthy but the politically well-connected, to
cronies, and family members of influential politicians they often end up fostering a bubble. South Korean
chaebols, Japanese keiretsu, as well as American
conglomerates frequently used these cheap funds to prop
up their stock or to invest in real estate, driving prices up
in both markets artificially.
Moreover, despite decades of bitter experiences - from
Mexico in 1982 to Asia in 1997 and Russia in 1998 financial institutions still bow to fads and fashions. They
act herd-like in conformity with "lending trends". They
shift assets to garner the highest yields in the shortest
possible period of time. In this respect, they are not very
different from investors in pyramid investment schemes.
II. Case Study - The Savings and Loans Associations
Bailout
Also published by United Press International (UPI)
Asset bubbles - in the stock exchange, in the real estate or
the commodity markets - invariably burst and often lead
to banking crises. One such calamity struck the USA in
1986-1989. It is instructive to study the decisive reaction

of the administration and Congress alike. They tackled
both the ensuing liquidity crunch and the structural flaws
exposed by the crisis with tenacity and skill. Compare this
to the lackluster and hesitant tentativeness of the current
lot. True, the crisis - the result of a speculative bubble concerned the banking and real estate markets rather than
the capital markets. But the similarities are there.
The savings and loans association, or the thrift, was a
strange banking hybrid, very much akin to the building
society in Britain. It was allowed to take in deposits but
was really merely a mortgage bank. The Depository
Institutions Deregulation and Monetary Control Act of
1980 forced S&L's to achieve interest parity with
commercial banks, thus eliminating the interest ceiling on
deposits which they enjoyed hitherto.
But it still allowed them only very limited entry into
commercial and consumer lending and trust services.
Thus, these institutions were heavily exposed to the
vicissitudes of the residential real estate markets in their
respective regions. Every normal cyclical slump in
property values or regional economic shock - e.g., a
plunge in commodity prices - affected them
disproportionately.
Interest rate volatility created a mismatch between the
assets of these associations and their liabilities. The
negative spread between their cost of funds and the yield
of their assets - eroded their operating margins. The 1982
Garn-St. Germain Depository Institutions Act encouraged
thrifts to convert from mutual - i.e., depositor-owned associations to stock companies, allowing them to tap the
capital markets in order to enhance their faltering net
worth.

But this was too little and too late. The S&L's were
rendered unable to further support the price of real estate
by rolling over old credits, refinancing residential equity,
and underwriting development projects. Endemic
corruption and mismanagement exacerbated the ruin. The
bubble burst.
Hundreds of thousands of depositors scrambled to
withdraw their funds and hundreds of savings and loans
association (out of a total of more than 3,000) became
insolvent instantly, unable to pay their depositors. They
were besieged by angry - at times, violent - clients who
lost their life savings.
The illiquidity spread like fire. As institutions closed their
gates, one by one, they left in their wake major financial
upheavals, wrecked businesses and homeowners, and
devastated communities. At one point, the contagion
threatened the stability of the entire banking system.
The Federal Savings and Loans Insurance Corporation
(FSLIC) - which insured the deposits in the savings and
loans associations - was no longer able to meet the claims
and, effectively, went bankrupt. Though the obligations of
the FSLIC were never guaranteed by the Treasury, it was
widely perceived to be an arm of the federal government.
The public was shocked. The crisis acquired a political
dimension.
A hasty $300 billion bailout package was arranged to
inject liquidity into the shriveling system through a
special agency, the FHFB. The supervision of the banks
was subtracted from the Federal Reserve. The role of the
Federal Deposit Insurance Corporation (FDIC) was
greatly expanded.

Prior to 1989, savings and loans were insured by the nowdefunct FSLIC. The FDIC insured only banks. Congress
had to eliminate FSLIC and place the insurance of thrifts
under FDIC. The FDIC kept the Bank Insurance Fund
(BIF) separate from the Savings Associations Insurance
Fund (SAIF), to confine the ripple effect of the meltdown.
The FDIC is designed to be independent. Its money comes
from premiums and earnings of the two insurance funds,
not from Congressional appropriations. Its board of
directors has full authority to run the agency. The board
obeys the law, not political masters. The FDIC has a
preemptive role. It regulates banks and savings and loans
with the aim of avoiding insurance claims by depositors.
When an institution becomes unsound, the FDIC can
either shore it up with loans or take it over. If it does the
latter, it can run it and then sell it as a going concern, or
close it, pay off the depositors and try to collect the loans.
At times, the FDIC ends up owning collateral and trying
to sell it.
Another outcome of the scandal was the Resolution Trust
Corporation (RTC). Many savings and loans were treated
as "special risk" and placed under the jurisdiction of the
RTC until August 1992. The RTC operated and sold these
institutions - or paid off the depositors and closed them. A
new government corporation (Resolution Fund
Corporation, RefCorp) issued federally guaranteed bailout
bonds whose proceeds were used to finance the RTC until
1996.
The Office of Thrift Supervision (OTS) was also
established in 1989 to replace the dismantled Federal
Home Loan Board (FHLB) in supervising savings and
loans. OTS is a unit within the Treasury Department, but

law and custom make it practically an independent
agency.
The Federal Housing Finance Board (FHFB) regulates the
savings establishments for liquidity. It provides lines of
credit from twelve regional Federal Home Loan Banks
(FHLB). Those banks and the thrifts make up the Federal
Home Loan Bank System (FHLBS). FHFB gets its funds
from the System and is independent of supervision by the
executive branch.
Thus a clear, streamlined, and powerful regulatory
mechanism was put in place. Banks and savings and loans
abused the confusing overlaps in authority and regulation
among numerous government agencies. Not one regulator
possessed a full and truthful picture. Following the
reforms, it all became clearer: insurance was the FDIC's
job, the OTS provided supervision, and liquidity was
monitored and imparted by the FHLB.
Healthy thrifts were coaxed and cajoled to purchase less
sturdy ones. This weakened their balance sheets
considerably and the government reneged on its promises
to allow them to amortize the goodwill element of the
purchase over 40 years. Still, there were 2,898 thrifts in
1989. Six years later, their number shrank to 1,612 and it
stands now at less than 1,000. The consolidated
institutions are bigger, stronger, and better capitalized.
Later on, Congress demanded that thrifts obtain a bank
charter by 1998. This was not too onerous for most of
them. At the height of the crisis the ratio of their
combined equity to their combined assets was less than
1%. But in 1994 it reached almost 10% and remained
there ever since.

This remarkable turnaround was the result of serendipity
as much as careful planning. Interest rate spreads became
highly positive. In a classic arbitrage, savings and loans
paid low interest on deposits and invested the money in
high yielding government and corporate bonds. The
prolonged equity bull market allowed thrifts to float new
stock at exorbitant prices.
As the juridical relics of the Great Depression - chiefly
amongst them, the Glass-Steagall Act - were repealed,
banks were liberated to enter new markets, offer new
financial instruments, and spread throughout the USA.
Product and geographical diversification led to enhanced
financial health.
But the very fact that S&L's were poised to exploit these
opportunities is a tribute to politicians and regulators alike
- though except for setting the general tone of urgency and
resolution, the relative absence of political intervention in
the handling of the crisis is notable. It was managed by
the autonomous, able, utterly professional, largely apolitical Federal Reserve. The political class provided the
professionals with the tools they needed to do the job.
This mode of collaboration may well be the most
important lesson of this crisis.
III. Case Study - Wall Street, October 1929
Also published by United Press International (UPI)
Claud Cockburn, writing for the "Times of London" from
New-York, described the irrational exuberance that
gripped the nation just prior to the Great Depression. As
Europe wallowed in post-war malaise, America seemed to
have discovered a new economy, the secret of
uninterrupted growth and prosperity, the fount of

transforming technology:
"The atmosphere of the great boom was savagely exciting,
but there were times when a person with my European
background felt alarmingly lonely. He would have liked to
believe, as these people believed, in the eternal upswing
of the big bull market or else to meet just one person with
whom he might discuss some general doubts without
being regarded as an imbecile or a person of deliberately
evil intent - some kind of anarchist, perhaps."
The greatest analysts with the most impeccable credentials
and track records failed to predict the forthcoming crash
and the unprecedented economic depression that followed
it. Irving Fisher, a preeminent economist, who, according
to his biographer-son, Irving Norton Fisher, lost the
equivalent of $140 million in today's money in the crash,
made a series of soothing predictions. On October 22 he
uttered these avuncular statements: "Quotations have not
caught up with real values as yet ... (There is) no cause for
a slump ... The market has not been inflated but merely
readjusted..."
Even as the market convulsed on Black Thursday, October
24, 1929 and on Black Tuesday, October 29 - the New
York Times wrote: "Rally at close cheers brokers, bankers
optimistic".
In an editorial on October 26, it blasted rabid speculators
and compliant analysts: "We shall hear considerably less
in the future of those newly invented conceptions of
finance which revised the principles of political economy
with a view solely to fitting the stock market's vagaries.''
But it ended thus: "(The Federal Reserve has) insured the
soundness of the business situation when the speculative
markets went on the rocks.''

Compare this to Alan Greenspan Congressional testimony
this summer: "While bubbles that burst are scarcely
benign, the consequences need not be catastrophic for the
economy ... (The Depression was brought on by) ensuing
failures of policy."
Investors, their equity leveraged with bank and broker
loans, crowded into stocks of exciting "new technologies",
such as the radio and mass electrification. The bull market
- especially in issues of public utilities - was fueled by
"mergers, new groupings, combinations and good
earnings" and by corporate purchasing for "employee
stock funds".
Cautionary voices - such as Paul Warburg, the influential
banker, Roger Babson, the "Prophet of Loss" and
Alexander Noyes, the eternal Cassandra from the New
York Times - were derided. The number of brokerage
accounts doubled between March 1927 and March 1929.
When the market corrected by 8 percent between March
18-27 - following a Fed induced credit crunch and a series
of mysterious closed-door sessions of the Fed's board bankers rushed in. The New York Times reported:
"Responsible bankers agree that stocks should now be
supported, having reached a level that makes them
attractive.'' By August, the market was up 35 percent on
its March lows. But it reached a peak on September 3 and
it was downhill since then.
On October 19, five days before "Black Thursday",
Business Week published this sanguine prognosis:
"Now, of course, the crucial weaknesses of such periods price inflation, heavy inventories, over-extension of
commercial credit - are totally absent. The security market

seems to be suffering only an attack of stock indigestion...
There is additional reassurance in the fact that, should
business show any further signs of fatigue, the banking
system is in a good position now to administer any needed
credit tonic from its excellent Reserve supply."
The crash unfolded gradually. Black Thursday actually
ended with an inspiring rally. Friday and Saturday trading ceased only on Sundays - witnessed an upswing
followed by mild profit taking. The market dropped 12.8
percent on Monday, with Winston Churchill watching
from the visitors' gallery - incurring a loss of $10-14
billion.
The Wall Street Journal warned naive investors:
"Many are looking for technical corrective reactions
from time to time, but do not expect these to disturb
the upward trend for any prolonged period."
The market plummeted another 11.7 percent the next day though trading ended with an impressive rally from the
lows. October 31 was a good day with a "vigorous,
buoyant rally from bell to bell". Even Rockefeller joined
the myriad buyers. Shares soared. It seemed that the worst
was over.
The New York Times was optimistic:
"It is thought that stocks will become stabilized at their
actual worth levels, some higher and some lower than the
present ones, and that the selling prices will be guided in
the immediate future by the worth of each particular
security, based on its dividend record, earnings ability and
prospects. Little is heard in Wall Street these days about
'putting stocks up."

But it was not long before irate customers began blaming
their stupendous losses on advice they received from their
brokers. Alec Wilder, a songwriter in New York in 1929,
interviewed by Stud Terkel in "Hard Times" four decades
later, described this typical exchange with his money
manager:
"I knew something was terribly wrong because I heard
bellboys, everybody, talking about the stock market.
About six weeks before the Wall Street Crash, I persuaded
my mother in Rochester to let me talk to our family
adviser. I wanted to sell stock which had been left me by
my father. He got very sentimental: 'Oh your father
wouldn't have liked you to do that.' He was so persuasive,
I said O.K. I could have sold it for $160,000. Four years
later, I sold it for $4,000."
Exhausted and numb from days of hectic trading and back
office operations, the brokerage houses pressured the
stock exchange to declare a two day trading holiday.
Exchanges around North America followed suit.
At first, the Fed refused to reduce the discount rate.
"(There) was no change in financial conditions which the
board thought called for its action." - though it did inject
liquidity into the money market by purchasing
government bonds. Then, it partially succumbed and
reduced the New York discount rate, which, curiously,
was 1 percent above the other Fed districts - by 1 percent.
This was too little and too late. The market never
recovered after November 1. Despite further reductions in
the discount rate to 4 percent, it shed a whopping 89
percent in nominal terms when it hit bottom three years
later.
Everyone was duped. The rich were impoverished

overnight. Small time margin traders - the forerunners of
today's day traders - lost their shirts and much else
besides. The New York Times:
"Yesterday's market crash was one which largely affected
rich men, institutions, investment trusts and others who
participate in the market on a broad and intelligent scale.
It was not the margin traders who were caught in the rush
to sell, but the rich men of the country who are able to
swing blocks of 5,000, 10,000, up to 100,000 shares of
high-priced stocks. They went overboard with no more
consideration than the little trader who was swept out on
the first day of the market's upheaval, whose prices, even
at their lowest of last Thursday, now look high by
comparison ... To most of those who have been in the
market it is all the more awe-inspiring because their
financial history is limited to bull markets."
Overseas - mainly European - selling was an important
factor. Some conspiracy theorists, such as Webster Tarpley
in his "British Financial Warfare", supported by
contemporary reporting by the likes of "The Economist",
went as far as writing:
"When this Wall Street Bubble had reached gargantuan
proportions in the autumn of 1929, (Lord) Montagu
Norman (governor of the Bank of England 1920-1944)
sharply (upped) the British bank rate, repatriating British
hot money, and pulling the rug out from under the Wall
Street speculators, thus deliberately and consciously
imploding the US markets. This caused a violent
depression in the United States and some other countries,
with the collapse of financial markets and the contraction
of production and employment. In 1929, Norman
engineered a collapse by puncturing the bubble."

The crash was, in large part, a reaction to a sharp reversal,
starting in 1928, of the reflationary, "cheap money",
policies of the Fed intended, as Adolph Miller of the Fed's
Board of Governors told a Senate committee, "to bring
down money rates, the call rate among them, because of
the international importance the call rate had come to
acquire. The purpose was to start an outflow of gold - to
reverse the previous inflow of gold into this country (back
to Britain)." But the Fed had already lost control of the
speculative rush.
The crash of 1929 was not without its Enrons and
World.com's. Clarence Hatry and his associates admitted
to forging the accounts of their investment group to show
a fake net worth of $24 million British pounds - rather
than the true picture of 19 billion in liabilities. This led to
forced liquidation of Wall Street positions by harried
British financiers.
The collapse of Middle West Utilities, run by the energy
tycoon, Samuel Insull, exposed a web of offshore holding
companies whose only purpose was to hide losses and
disguise leverage. The former president of NYSE, Richard
Whitney was arrested for larceny.
Analysts and commentators thought of the stock exchange
as decoupled from the real economy. Only one tenth of the
population was invested - compared to 40 percent today.
"The World" wrote, with more than a bit of
Schadenfreude: "The country has not suffered a
catastrophe ... The American people ... has been gambling
largely with the surplus of its astonishing prosperity."
"The Daily News" concurred: "The sagging of the stocks
has not destroyed a single factory, wiped out a single farm
or city lot or real estate development, decreased the

productive powers of a single workman or machine in the
United States." In Louisville, the "Herald Post"
commented sagely: "While Wall Street was getting rid of
its weak holder to their own most drastic punishment,
grain was stronger. That will go to the credit side of the
national prosperity and help replace that buying power
which some fear has been gravely impaired."
During the Coolidge presidency, according to the
Encyclopedia Britannica, "stock dividends rose by 108
percent, corporate profits by 76 percent, and wages by 33
percent. In 1929, 4,455,100 passenger cars were sold by
American factories, one for every 27 members of the
population, a record that was not broken until 1950.
Productivity was the key to America's economic growth.
Because of improvements in technology, overall labour
costs declined by nearly 10 percent, even though the
wages of individual workers rose."
Jude Waninski adds in his tome "The Way the World
Works" that "between 1921 and 1929, GNP grew to
$103.1 billion from $69.6 billion. And because prices
were falling, real output increased even faster." Tax rates
were sharply reduced.
John Kenneth Galbraith noted these data in his seminal
"The Great Crash":
"Between 1925 and 1929, the number of manufacturing
establishments increased from 183,900 to 206,700; the
value of their output rose from $60.8 billions to $68
billions. The Federal Reserve index of industrial
production which had averaged only 67 in 1921 ... had
risen to 110 by July 1928, and it reached 126 in June 1929
... (but the American people) were also displaying an
inordinate desire to get rich quickly with a minimum of

physical effort."
Personal borrowing for consumption peaked in 1928 though the administration, unlike today, maintained twin
fiscal and current account surpluses and the USA was a
large net creditor. Charles Kettering, head of the research
division of General Motors described consumeritis thus,
just days before the crash: "The key to economic
prosperity is the organized creation of dissatisfaction."
Inequality skyrocketed. While output per man-hour shot
up by 32 percent between 1923 and 1929, wages crept up
only 8 percent. In 1929, the top 0.1 percent of the
population earned as much as the bottom 42 percent.
Business-friendly administrations reduced by 70 percent
the exorbitant taxes paid by those with an income of more
than $1 million. But in the summer of 1929, businesses
reported sharp increases in inventories. It was the
beginning of the end.
Were stocks overvalued prior to the crash? Did all stocks
collapse indiscriminately? Not so. Even at the height of
the panic, investors remained conscious of real values. On
November 3, 1929 the shares of American Can, General
Electric, Westinghouse and Anaconda Copper were still
substantially higher than on March 3, 1928.
John Campbell and Robert Shiller, author of "Irrational
Exuberance", calculated, in a joint paper titled "Valuation
Ratios and the Lon-Run Market Outlook: An Update"
posted on Yale University' s Web Site, that share prices
divided by a moving average of 10 years worth of
earnings reached 28 just prior to the crash. Contrast this
with 45 on March 2000.
In an NBER working paper published December 2001 and

tellingly titled "The Stock Market Crash of 1929 - Irving
Fisher was Right", Ellen McGrattan and Edward Prescott
boldly claim: "We find that the stock market in 1929 did
not crash because the market was overvalued. In fact, the
evidence strongly suggests that stocks were undervalued,
even at their 1929 peak."
According to their detailed paper, stocks were trading at
19 times after-tax corporate earning at the peak in 1929, a
fraction of today's valuations even after the recent
correction. A March 1999 "Economic Letter" published by
the Federal Reserve Bank of San-Francisco
wholeheartedly concurs. It notes that at the peak, prices
stood at 30.5 times the dividend yield, only slightly above
the long term average.
Contrast this with an article published in June 1990 issue
of the "Journal of Economic History" by Robert Barsky
and Bradford De Long and titled "Bull and Bear Markets
in the Twentieth Century":
"Major bull and bear markets were driven by shifts in
assessments of fundamentals: investors had little
knowledge of crucial factors, in particular the long run
dividend growth rate, and their changing expectations of
average dividend growth plausibly lie behind the major
swings of this century."
Jude Waninski attributes the crash to the disintegration of
the pro-free-trade coalition in the Senate which later led to
the notorious Smoot-Hawley Tariff Act of 1930. He traces
all the important moves in the market between March
1929 and June 1930 to the intricate protectionist danse
macabre in Congress.
This argument may never be decided. Is a similar crash on

the cards? This cannot be ruled out. The 1990's resembled
the 1920's in more than one way. Are we ready for a
recurrence of 1929? About as we were prepared in 1928.
Human nature - the prime mover behind market
meltdowns - seemed not to have changed that much in
these intervening seven decades.
Will a stock market crash, should it happen, be followed
by another "Great Depression"? It depends which kind of
crash. The short term puncturing of a temporary bubble e.g., in 1962 and 1987 - is usually divorced from other
economic fundamentals. But a major correction to a
lasting bull market invariably leads to recession or worse.
As the economist Hernan Cortes Douglas reminds us in
"The Collapse of Wall Street and the Lessons of History"
published by the Friedberg Mercantile Group, this was the
sequence in London in 1720 (the infamous "South Sea
Bubble"), and in the USA in 1835-40 and 1929-32.
IV. Britain's Real Estate
Also published by United Press International (UPI)
Written September 2002
Updated April 2005
The five ghastly "Jack the Ripper" murders took place in
an area less than a quarter square mile in size. Houses in
this haunting and decrepit no man's land straddling the
City and metropolitan London could be had for 25-50,000
British pounds as late as a decade ago. How things
change!

The general buoyancy in real estate prices in the capital
coupled with the adjacent Spitalfields urban renewal
project have lifted prices. A house not 50 yards from the
scene of the Ripper's last - and most ghoulish - slaying
now sells for over 1 million pounds. In central London,
one bedroom apartments retail for an outlandish half a
million.
According to research published in September 2002 by
Halifax, the UK's largest mortgage lender, the number of
1 million pound homes sold has doubled in 1999-2002 to
2600. By 2002, it has increased elevenfold since 1995.
According to The Economist's house price index, prices
rose by a further 15.6% in 2003, 10.2% in 2004 and a
whopping 147% in total since 1997. In Greater London,
one in every 90 homes fetches even a higher price. The
average UK house now costs 100,000 pounds. In the
USA, the ratios of house prices to rents and to median
income are at historic highs.
One is reminded of the Japanese boast, at the height of
their realty bubble, that the grounds of the royal palace in
Tokyo are worth more than the entire real estate of
Manhattan. Is Britain headed the same way?
A house - much like a Big Mac - is a basket of raw
materials, goods, and services. But, unlike the Big Mac and the purchasing power index it spawned - houses are

also investment vehicles and stores of value. They yield
often tax exempt capital gains, rental income, or benefits
from occupying them (rent payments saved). Real estate is
used to hedge against inflation, save for old age, and
speculate. Prices of residential and commercial property
reflect scarcity, investment fads, and changing moods.
Homeowners in both the UK and the USA - spurred on by
aggressive marketing and the lowest interest rates in 30
years - have been refinancing old, more expensive,
mortgages and heavily borrowing against their "equity" i.e., against the meteoric rise in the market prices of their
abodes.
According to the Milken Institute in Los Angeles, asset
bubbles tend to both enhance and cannibalize each other.
Profits from surging tradable securities are used to buy
property and drive up its values. Borrowing against
residential equity fuels overvaluations in fervid stock
exchanges. When one bubble bursts - the other initially
benefits from an influx of funds withdrawn in panic from
the shriveling alternative.
Quantitatively, a considerably larger share of the nation's
wealth is tied in real estate than in the capital markets.
Yet, the infamous wealth effect - an alleged fluctuation in
the will to consume as a result of changing fortunes in the
stock exchange - is equally inconspicuous in the realty

markets. It seems that consumption is correlated with
lifelong projected earnings rather than with the state of
one's savings and investments.
This is not the only counter-intuitive finding. Asset
inflation - no matter how vertiginous - rarely spills into
consumer prices. The recent bubbles in Japan and the
USA, for instance, coincided with a protracted period of
disinflation. The bursting of bubbles does have a
deflationary effect, though.
In a late 2002 survey of global house price movements,
"The Economist" concluded that real estate inflation is a
global phenomenon. Though Britain far outpaces the
United States and Italy (65% rise since 1997), it falls
behind Ireland (179%) and South Africa (195%). It is in
league with Australia (with 113%) and Spain (132%).
The paper notes wryly:
"Just as with equities in the late 1990s, property bulls
are now coming up with bogus arguments for why
rampant house-price inflation is sure to continue.
Demographic change ... Physical restrictions and tough
planning laws ... Similar arguments were heard in
Japan in the late 1980s and Germany in the early 1990s
- and yet in recent years house prices in these two
countries have been falling. British house prices also
tumbled in the late 1980s."

They are bound to do so again. In the long run, the rise in
house prices cannot exceed the increase in disposable
income. The effects of the bursting of a property bubble
are invariably more pernicious and prolonged than the
outcomes of a bear market in stocks. Real estate is much
more leveraged. Debt levels can well exceed home equity
("negative equity") in a downturn. Nowadays, loans are
not eroded by high inflation. Adjustable rate mortgages one third of the annual total in the USA - will make sure
that the burden of real indebtedness mushrooms as interest
rates rise.
The Economist (April 2005):
"An IMF study on asset bubbles estimates that 40% of
housing booms are followed by housing busts, which
last for an average of four years and see an average
decline of roughly 30% in home values. But given how
many homebuyers in booming markets seem to be
basing their purchasing decisions on expectations of
outsized returnsâ&#x20AC;&#x201D;a recent survey of buyers in Los
Angeles indicated that they expected their homes to
increase in value by a whopping 22% a year over the
next decadeâ&#x20AC;&#x201D;nasty downturns in at least some markets
seem likely."
With both the equity and realty markets in gloom, people
revert to cash and bonds and save more - leading to

deflation or recession or both. Japan is a prime example of
such a shift of investment preferences. When prices
collapse sufficiently to become attractive, investors pile
back into both the capital and real estate markets. This
cycle is as old and as inevitable as human greed and fear.
Post Script
In 2007, a collapse in the subprime mortgage market in
the United States precipitated a sharp global decline in
housing starts and prices - as predicted. The year after,
this led to a global credit crunch, the destabilization of the
banking system, the demise of all the major investment
banks in the USA, and recession throughout the
industrialized world. The resultant drop in commodity and
energy prices caused the slowdown to spread to
developing countries as well.
IV. Notes on the Credit Crisis of 2007-9
The global crisis of 2007-9 was, actually, a confluence of
unrelated problems on three continents. In the United
States, investment banks were brought down by hyperleveraged investments in ill-understood derivatives. As
stock exchanges plummeted, the resulting devastation and
wealth destruction spilled over into the real economy and
caused a recession which is bound to be mild by historical
standards.
Depending heavily on imported energy and exported
goods, Europe's economy faced a marked slowdown as

the region's single currency, the euro, appreciated strongly
against all major currencies; as China, India, and other
low-wage Asian countries became important exporters; as
the price of energy products and oil skyrocketed; and as
real estate bubbles burst in countries like Spain and
Ireland. Additionally, European banks were heavily
leveraged and indebted - far more than their counterparts
across the Atlantic. Governments throughout the continent
were forced to bail out one ailing institution after another,
taxing further their limited counter-cyclical resources.
Simultaneously, in Asia, growth rates began to decelerate.
Massive exposure to American debt, both public and
private, served a vector of contagion. The weakening of
traditional export markets affected adversely industries
and employment. Stock exchanges tumbled.
The 2007-9 upheaval was so all-pervasive and so
reminiscent of the beginnings of the Great Depression that
it brought about a realignment and re-definition of the
roles of the main economic actors: the state, the central
banks, financial institutions of all stripes (both those
regulated and in the "shadow banking" sector), the
investment industries, and the various marketplaces (the
stock exchanges, foremost).
1. Central Banks
The global credit crunch induced by the subprime
mortgage crisis in the United States, in the second half of
2007, engendered a tectonic and paradigmatic shift in the
way central banks perceive themselves and their role in
the banking and financial systems.
On December 12, 2007, America's Federal Reserve, the
Bank of England, the European Central Bank (ECB), the

Bank of Canada and the Swiss National Bank, as well as
Japan's and Sweden's central banks joined forces in a plan
to ease the worldwide liquidity squeeze.
This collusion was a direct reaction to the fact that more
conventional instruments have failed. Despite soaring
spreads between the federal funds rate and the LIBOR
(charged in interbank lending), banks barely touched
money provided via the Fed's discount window. Repeated
and steep cuts in interest rates and the establishment of
reciprocal currency-swap lines fared no better.
The Fed then proceeded to establish a "Term Auction
Facility (TAF)", doling out one-month loans to eligible
banks. The Bank of England multiplied fivefold its regular
term auctions for three months maturities. On December
18, the ECB lent 350 million euros to 390 banks at below
market rates.
In March 2008, the Fed lent 29 billion USD to JP Morgan
Chase to purchase the ailing broker-dealer Bear Stearns
and hundreds of billions of dollars to investment banks
through its discount window, hitherto reserved for
commercial banks. The Fed agreed to accept as collateral
securities tied to "prime" mortgages (by then in as much
trouble as their subprime brethren).
The Fed doled the funds out through anonymous auctions,
allowing borrowers to avoid the stigma attached to
accepting money from a lender of last resort. Interest rates
for most lines of credit, though, were set by the markets in
(sometimes anonymous) auctions, rather than directly by
the central banks, thus removing the central banks' ability
to penalize financial institutions whose lax credit policies
were, to use a mild understatement, negligent.

Moreover, central banks broadened their range of
acceptable collateral to include prime mortgages and
commercial paper. This shift completed their
transformation from lenders of last resort. Central banks
now became the equivalents of financial marketplaces,
and akin to many retail banks. Fighting inflation - their
erstwhile raison d'etre - has been relegated to the back
burner in the face of looming risks of recession and
protectionism. In September 2008, the Fed even borrowed
money from the Treasury when its own resources were
depleted.
As The Economist neatly summed it up (in an article titled
"A dirty job, but Someone has to do it", dated December
13, 2007):
"(C)entral banks will now be more intricately involved
in the unwinding of the credit mess. Since more banks
have access to the liquidity auction, the central banks
are implicitly subsidising weaker banks relative to
stronger ones. By broadening the range of acceptable
collateral, the central banks are taking more risks onto
their balance sheets."
Regulatory upheaval is sure to follow. Investment banks
are likely to be subjected to the same strictures, reserve
requirements, and prohibitions that have applied to
commercial banks since 1934. Supervisory agencies and
functions will be consolidated and streamlined.
Ultimately, the state is the mother of all insurers, the
master policy, the supreme underwriter. When markets
fail, insurance firm recoil, and financial instruments
disappoint - the government is called in to pick up the
pieces, restore trust and order and, hopefully, retreat more
gracefully than it was forced to enter.

The state would, therefore, do well to regulate all financial
instruments: deposits, derivatives, contracts, loans,
mortgages, and all other deeds that are exchanged or
traded, whether publicly (in an exchange) or privately.
Trading in a new financial instrument should be allowed
only after it was submitted for review to the appropriate
regulatory authority; a specific risk model was
constructed; and reserve requirements were established
and applied to all the players in the financial services
industry, whether they are banks or other types of
intermediaries.
2. Common Investment Schemes
The credit and banking crisis of 2007-9 has cast in doubt
the three pillars of modern common investment schemes.
Mutual funds (known in the UK as "unit trusts"), hedge
funds, and closed-end funds all rely on three assumptions:
Assumption number one
That risk inherent in assets such as stocks can be
"diversified away". If one divides one's capital and invests
it in a variety of financial instruments, sectors, and
markets, the overall risk of one's portfolio of investments
is lower than the risk of any single asset in said portfolio.
Yet, in the last decade, markets all over the world have
moved in tandem. These highly-correlated ups and downs
gave the lie to the belief that they were in the process of
"decoupling" and could, therefore, be expected to
fluctuate independently of each other. What the crisis has
revealed is that contagion transmission vectors and
mechanisms have actually become more potent as barriers
to flows of money and information have been lowered.
Assumption number two

That investment "experts" can and do have an advantage
in picking "winner" stocks over laymen, let alone over
random choices. Market timing coupled with access to
information and analysis were supposed to guarantee the
superior performance of professionals. Yet, they didn't.
Few investment funds beat the relevant stock indices on a
regular, consistent basis. The yields on "random walk" and
stochastic (random) investment portfolios often surpass
managed funds. Index or tracking funds (funds who
automatically invest in the stocks that compose a stock
market index) are at the top of the table, leaving "stars",
"seers", "sages", and "gurus" in the dust.
This manifest market efficiency is often attributed to the
ubiquity of capital pricing models. But, the fact that
everybody uses the same software does not necessarily
mean that everyone would make the same stock picks.
Moreover, the CAPM and similar models are now being
challenged by the discovery and incorporation of
information asymmetries into the math. Nowadays, not all
fund managers are using the same mathematical models.
A better explanation for the inability of investment experts
to beat the overall performance of the market would
perhaps be information overload. Recent studies have
shown that performance tends to deteriorate in the
presence of too much information.
Additionally, the failure of gatekeepers - from rating
agencies to regulators - to force firms to provide reliable
data on their activities and assets led to the ascendance of
insider information as the only credible substitute. But,
insider or privileged information proved to be as
misleading as publicly disclosed data. Finally, the market
acted more on noise than on signal. As we all know, noise

it perfectly randomized. Expertise and professionalism
mean nothing in a totally random market.
Assumption number three
That risk can be either diversified away or parceled out
and sold. This proved to be untenable, mainly because the
very nature of risk is still ill-understood: the samples used
in various mathematical models were biased as they relied
on data pertaining only to the recent bull market, the
longest in history.
Thus, in the process of securitization, "risk" was
dissected, bundled and sold to third parties who were
equally at a loss as to how best to evaluate it. Bewildered,
participants and markets lost their much-vaunted ability to
"discover" the correct prices of assets. Investors and banks
got spooked by this apparent and unprecedented failure
and stopped investing and lending. Illiquidity and panic
ensued.
If investment funds cannot beat the market and cannot
effectively get rid of portfolio risk, what do we need them
for?
The short answer is: because it is far more convenient to
get involved in the market through a fund than directly.
Another reason: index and tracking funds are excellent
ways to invest in a bull market.
3. Capital-Allocating Institutions
The main role of banks, well into the 1920, was to allocate
capital to businesses (directly and through consumer
credits and mortgages). Deposit-taking was a core
function and the main source of funding. As far as

depositors were concerned, banks guaranteed the safety
and liquidity of the store of value (cash and cashequivalents).
In the 1920, stock exchanges began to compete with
banks by making available to firms other means of raising
capital (IPOs - initial public offerings). This activity
gradually became as important as the stock exchange's
traditional competence: price discovery (effected through
the structured interactions of willing buyers and sellers).
This territorial conflict led to an inevitable race to the
bottom in terms of the quality of debtors and, ultimately,
to the crash of 1929 and the Great Depression that ensued.
Banks then were reduced to retail activities, having lost
their investment services to hybrids known as "investment
banks".
The invention of junk bonds in the 1980s heralded a
whole new era. A parallel, unregulated financial system
has emerged which catered to the needs of businesses to
raise risk capital and to the needs of those who provided
such funds to rid themselves of the hazards inherent in
their investments. Consumer credits and mortgages, for
instance, were financed by traditional banking businesses.
The risks associated with such lending were securitized
and sold to third parties.
As expertise evolved and experience accumulated,

financial operators learned to slice the hazards, evaluate
them using value-at-risk mathematical models, tailor them
to the needs of specific customer profiles, hedge them
with complex derivatives, and trade them in unofficial,
unregulated, though highly liquid amorphous, virtual
"marketplaces".
Thus, stock exchanges have begun to lose their capital
allocation functions to private equity funds, hedge funds,
investment banks, and pension funds. In the process, such
activities have become even more opaque and less
regulated than before. This lack of transparency led to
pervasive counterparty distrust and difficulties in price
discovery. Ultimately, when the prices of underlying
assets (such as housing) began to tumble, all liquidity
drained and markets seized and froze.
Thus, at the end of 2006, the global financial system was
comprised of three main groups of actors: traditional retail
banks whose main role was deposit taking and doling out
consumer credits; exchanges whose main functions were
price discovery and the provision of liquidity; and
investment banks and their surrogates and special purpose
vehicles whose principal job was the allocation of capital
to businesses and the mitigation of risk via securitization
and insurance (hedging).
Yet, these unregulated investment banks were also often

under-capitalized and hyper-leveraged partnerships (at
least until the late 1990s, when some of them went
public). This is precisely why they had invented all
manner of complex financial instruments intended to
remove credit-related risks from their books by selling it
to third parties. Physicists, analysts, and rating agencies
all agreed that the risk attendant to these derivatives can
be calculated and determined and that many of them were
risk-free (as long as markets were liquid, of course).
The business strategy of the investment banks was viable.
It should have worked perfectly had they not committed a
primal sin: they have entered the fray not only as brokers,
dealers, and mediators, but also as investors and gamblers
(principals), taking on huge positions, often improperly
hedged ("naked"). When these bets soured, the capital
base of these institutions was wiped out, sometimes
literally overnight. The very financial instruments that
were meant to alleviate and reallocate risk (such as
collateralized debt obligations - CDOs) have turned into
hazardous substances, as investors (and investment banks)
gambled on the direction of the economy, specific sectors,
or firms.
In hindsight, the "shadow banks" subverted the very
foundations of modern finance: they created money
(modifying the money-printing monopoly of central
banks); they obfuscated the process of price discovery and

thus undermined the price signal (incidentally casting
doubt on symmetrical asset pricing models); they
interfered with the ability of cash and cash-equivalents to
serve as value stores and thus shook the trust in the entire
financial system; they amplified the negative
consequences of unbridled speculation (that is not related
to real-life economic activities and values); they leveraged
the instant dissemination of information to render markets
inefficient and unstable (a fact which requires a major
revision of efficient market hypotheses).
This systemic dysfunctioning of financial markets led
risk-averse investors to flee into safer havens:
commodities, oil, metals, real estate and, finally,
currencies and bonds. This was not merely a flight to
quality: it was an attempt to avoid the abstract and
fantastic "Alice in Wonderland" markets fostered by
investment banks and to reconnect with tangible reality
With the disappearance of investment banks (those who
survived became bank holding companies), traditional
banks are likely to regain some of their erstwhile
functions: the allocation to businesses and creditworthy
consumers and homeowners of deposit-based capital. The
various exchanges will also survive, but will largely be
confined to price discovery and the allocation of risk
capital. Some financial instruments will flourish (creditdefault swaps of all types), others will vanish (CDOs).

All in all, the financial scenery of 2010 will resemble
1910's more than it will 2005's. Back to basics and homegrown truths. At least until the next cataclysm.
V. The Crisis in Historical Context
Housing and financial crises often precede, or follow the
disintegration of empires. The dissolution of the Habsburg
and the British empires, as well as the implosion of the
USSR were all marked by the eruption and then
unwinding of imbalances in various asset, banking, and
financial markets.
The collapse of Communism in Europe and Asia led to the
emergence of a new middle class in these territories.
Flushed with enhanced earnings and access to bank
credits, its members unleashed a wave of unbridled
consumption (mainly of imported goods); and with a
rising mountain of savings, they scoured the globe for
assets to invest their capital in: from football clubs to
stocks and bonds.
The savings glut and the lopsided expansion of
international trade led to severe asymmetries in capital
flows and to the distortion of price signals. These, in turn,
encouraged leveraged speculation and arbitrage and
attempts to diversify away investment risks. The former
resulted in extreme volatility and the latter in opaqueness
and the breakdown of trust among market players and

agents.
VI. The Next Crisis: Imploding Bond Markets
Written: November 3, 2008
To finance enormous bailout packages for the financial
sector (and potentially the auto and mining industries) as
well as fiscal stimulus plans, governments will have to
issue trillions of US dollars in new bonds. Consequently,
the prices of bonds are bound to come under pressure
from the supply side.
But the demand side is likely to drive the next global
financial crisis: the crash of the bond markets.
As the Fed takes US dollar interest rates below 1% (and
with similar moves by the ECB, the Bank of England, and
other central banks), buyers are likely to lose interest in
government bonds and move to other high-quality, safe
haven assets. Risk-aversion, mitigated by the evident
thawing of the credit markets will cause investors to
switch their portfolios from cash and cash-equivalents to
more hazardous assets.
Moreover, as countries that hold trillions in government
bonds (mainly US treasuries) begin to feel the pinch of the
global crisis, they will be forced to liquidate their
bondholdings in order to finance their needs.

In other words, bond prices are poised to crash
precipitously. In the last 50 years, bond prices have
collapsed by more than 35% at least on three occasions.
This time around, though, such a turn of events will be
nothing short of cataclysmic: more than ever,
governments are relying on functional primary and
secondary bond markets for their financing needs. There
is no other way to raise the massive amounts of capital
needed to salvage the global economy.

Also Read
The Economics of Expectations
The Greatest Savings Crisis in History
The Typology of Financial Scandals
The Shadowy World of International Finance
Hawala, or the Bank that Never Was
Money Laundering in a Changed World
The Varieties of Corruption
Corruption and Transparency
Straf - Corruption in CEE
The Criminality of Transition
The Kleptocracies of the East

The Enrons of the East
Bully at Work - Interview with Tim Field
The Economics of Conspiracy Theories
The Industrious Spies
The Business of Torture
Fimaco Wouldn't Die - Russia's Missing Billions
Treasure Island Revisited - Maritime Piracy
Organ Trafficking in Eastern Europe
Begging Your Trust in Africa
Slush Funds

Return

The Future of the SEC
Interview with Gary Goodenow
Interview conducted August 2002
Updated June 2005
In June 2005, William H. Donaldson was forced to resign
as Chairman of the Securities and Exchange Commission
(SEC). The reason? As the New York Times put it:
"criticism that his enforcement was too heavy-handed".
President Bush chose California Rep. Christopher Cox, a
Republican, to replace him.
Gary Langan Goodenow is an attorney licensed to
practice in the State of Florida and the District of
Columbia. The Webmaster of
www.RealityAtTheSEC.com, he worked at the Miami
office of the SEC for about six years, in the Division of
Enforcement.
His experience is varied. As a staff attorney, he
investigated and prosecuted cases enforcing the federal
securities laws. As a branch chief, he supervised the work
of several staff attorneys. As a Senior Trial Counsel, he
was responsible for litigating about thirty enforcement
cases at any one time in federal court. As Senior Counsel,
he made the final recommendations on which cases the
office would investigate and prosecute, or decline.
He describes an experience he had after he left the SEC.
"I represented an Internet financial writer with a Web
site that touted stocks, Mr. Ted Melcher of SGA Whisper

Stocks. The SEC sued Ted because as he was singing
the praises of certain stocks in his articles, he was
selling them into a rising market. He got his shares from
the issuers in exchange for doing the promotional
touting. Unfortunately for him, the SEC and the
Department of Justice made an example of his case, and
he went to jail."
Q. The SEC is often accused of lax and intermittent
enforcement of the law. Is the problem with the
enforcement division - or with the law? Can you describe
a typical SEC investigation from start to finish?
A. The problem lies with both.
At the SEC, the best argument in support of a proposed
course of action is "that's what we did last time". That will
inevitably please the staff attorney's superiors.
SEC rules and regulations remind me of an old farmhouse
that has been altered and adapted, sometimes for
convenience, other times for necessity. But it has never
been just plain pulled down and rebuilt despite incredible
changes around it. To the uninitiated, the house is
rambling with hidden passages, dark corners, low ceilings,
folklore and horror stories, and accumulations of tons of
antique rubbish that sometimes no one â&#x20AC;&#x201C; not even some
SEC Commissioners â&#x20AC;&#x201C; can wade through.
Wandering from room to room in this farmhouse are the

SEC staff. Regretfully, I found that many are ignorant or
indifferent to their mission, or scornful of investors'
plight, too addicted to their petty specializations in their
detailed job descriptions, and way too prone to follow
only the well-trodden path.
They are stunned by the rapidity, multiplicity, immensity
and intelligence behind the scams. Their tools of research,
investigation and prosecution are confusingly changed
periodically when Congress passes some new "reform"
legislation, or a new Chairman or new Enforcement
Director issues some memo edict on a "new approach".
Staff attorneys typically bring investors only bad news
and are numbed by the latters' emotional reactions, in a
kind of "shell shock". The SEC lost one quarter of its staff
in the last two years. The turnover of its 1200 attorneys, at
14%, is nearly double the government's average.
One SEC official was quoted as saying "We are losing our
future â&#x20AC;&#x201C; the people who would have had the experience to
move into the senior ranks". Those that stay behind and
rise in the ranks are often the least inspired. At the SEC
enforcement division, one is often confronted with the
"evil of banality".
The SEC is empowered by the Securities Act of 1933
and the Securities Exchange Act of 1934 to seek
injunctive relief where it appears that a person is engaged

or about to engage in violations of the federal securities
laws. This is a civil remedy, not a criminal law
sanction. Under well-settled case law, the purpose of
injunctive relief is deterrence, rather than punishment, of
those who commit violations. Investors do not know that,
and are uniformly shocked when told.
The "likelihood requirement" means that, once the
Commission demonstrates a violation, for injunctive relief
it needs only show that there is some reasonable
likelihood of future violations. "Positive proof' of
likelihood, as one court demanded, is hard to provide. At
the other extreme, I had one former Commissioner tell me
that, as he understood the law, if the person is alive and
breathing, the Commission enforcement staff can show
likelihood of future violations.
The broad powers of the federal courts are used in
actions brought by the Commission to prevent securities
violators from enjoying the fruits of their misconduct. But
because this is a civil and not a criminal remedy, the SEC
has a unique rule where defendants can consent to an
injunction without "admitting or denying the allegations
of the complaint". This leads to what are called "waivers",
and I submit that "waivers" are the fundamental flaw in
U.S. securities laws enforcement.
In a nutshell, here is the problem. A "fraudster" commits

a fraud. The Commission sues for an injunction. The
fraudster consents to the injunction as per above. The
Court then orders the fraudster to "disgorge" his "ill gotten
gains" from the scam, usually within 30 days and with
interest.
In most cases, the fraudster doesn't pay it all and the
Commission moves to hold him in civil contempt for
disobeying the Court's order. The fraudster claims to the
Court that it is impossible for him to comply because the
money is gone and he is "without the financial means to
pay". The Commission then issues a "waiver" and that's
the way many cases end. Thus both sides can put the case
behind them. The fraudster agrees to the re-opening of the
case if he turns out to have lied.
This procedure is problematic. The Commission
typically alleges that these fraudsters have lied through
their teeth in securities sales - but is forced to accept their
word in an affidavit swearing that they have no money to
pay the disgorgement. So the waivers are based on an
assumption of credibility that has no basis in experience
and possibly none in fact.
Moreover, the Division of Enforcement has no
mechanism in place to check if the fraudster has, indeed,
lied. After the waiver, the files of the case get stored. The
case is closed. I don't know if there's even a central place

where the records of waivers are kept.
In the six years I was at the Commission, I never heard
of a case involving a breach of waiver affidavit. I doubt if
one has ever been brought by the Commission anywhere. UPI ought to do a Freedom Of Information Act
Request on that.
Something similar happens with the Commission's
much vaunted ability to levy civil penalties. The statute
requires that a court trial be held to determine the
egregiousness of the fraud. Based on its findings, the court
can levy the fines. But, according to some earlier nonSEC case law, a fraudster can ask for a jury trial regarding
the amount of the civil penalties because he or she lack
the means to pay them. U.S. district courts being as busy
as they are, there's no way the court is going to hold a jury
trial.
Instead, the fraudster consents to a court order "noting
the appropriateness of civil penalties for the case, but
declining to set them based on a demonstrated inability to
pay". Again, if the fraudster lied, the Commission can ask
the Court to revisit the issue.
Q. Internet fraud, corporate malfeasance, derivatives, offshore special purpose entities, multi-level marketing,
scams, money laundering - is the SEC up to it? Isn't its
staff overwhelmed and under-qualified?

A. The staff is overwhelmed. The longest serving are
often the least qualified because the talented usually leave.
We've already got the criminal statutes on the books for
criminal prosecution of securities fraud at the federal
level. Congress should pass a law deputizing staff
attorneys of the Commission Division of Enforcement,
with at least one-year experience and high performance
ratings, as Special Assistant United States Attorneys for
the prosecution of securities fraud. In other words, make
them part of the Department of Justice to make criminal,
not just civil cases, against the fraudsters.
The US Department of Justice does not have the person
power to pursue enough criminal securities cases in the
Internet Age. Commission attorneys have the expertise,
but not the legal right, to bring criminal prosecution. The
afore-described waiver system only makes the fraudsters
more confident that the potential gain from fraud
outweighs the risk.
I'd keep the civil remedies. In an ongoing fraud, with no
time to make out a criminal case, the Commission staff
can seek a Temporary Restraining Order and an asset
freeze. This more closely resembles the original intent of
Congress in the 1930s. But after the dust settles, the
investing public deserves to demand criminal
accountability for the fraud, not just waivers.

Q. Is the SEC - or at least its current head - in hock to
special interests, e.g., the accounting industry?
A. "In hock to special interests" is too explicit a statement
about US practice. It makes a good slogan for a Marxist
law school professor, but reality is far subtler.
By unwritten bipartisan agreement, the Chairman of the
SEC is always a political figure. Two of the five SEC
Commissioners are always Democrats, two Republicans,
and the Chairman belongs to the political party of the
President. I am curious to see if this same agreement will
apply to the boards established under the Sarbannes-Oxley
Act.
Thus, both parties typically choose a candidate for
Chairman of impeccable partisan credentials and
consistent adherence to the "party line". The less
connected, the less partisan, and academicians serve as
Commissioners, not Chairmen.
The Chairman's tenure normally overlaps with a specific
President's term in office, even when, as with President
Bush the elder following President Reagan, the same party
remains in power. SEC jobs lend themselves to lucrative
post-Commission employment. This explains the dearth of
"loyal opposition". Alumni pride themselves on their
connections following their departure.
The Chairman is no more and no less "in hock" than any

leading member of a US political party. Still, I faulted
Chairman Pitt, and became the first former member of
SEC management to call for his resignation, in an Op/Ed
item in the Miami Herald. In my view, he was
impermissibly indulgent of his former law clients at the
expense of SEC enforcement.
Q. What more could stock exchanges do to help the SEC?
A. At the risk of being flippant, enforce their own
rules. The major enforcement action against the
NASDAQ brokers a few years ago, for instance, was
toothless. Presently, Merrill Lynch is being scrutinized by
the State of New York, but there is not a word from the
NYSE.
Q. Do you regard the recent changes to the law especially the Sarbanes-Oxley Act - as toothless or an
important enhancement to the arsenal of law enforcement
agencies? Do you think that the SEC should have any
input in professional self-regulating and regulatory bodies,
such as the recently established accountants board?
A. It remains to be seen. The Act establishes a Public
Accounting Oversight Board ("the Board"). It reflects one
major aspect of SEC enforcement practice: unlike in many
countries, the SEC does not recognize an
accountant/client privilege, though it does recognize an
attorney/client privilege.

Regrettably, in my experience, attorneys organize at least
as much securities fraud as accountants. Yet in the US,
one would never see an "attorneys oversight board". For
one thing, Congress has more attorneys than accountants.
Section 3 of the Act, titled "Commission Rules and
Enforcement", treats a violation of the Rules of the
Public Company Accounting Oversight Board as a
violation of the '34 Act, giving rise to the same
penalties. It is unclear if this means waiver after waiver,
as in present SEC enforcement. Even if it does, the Rules
may still be more effective because US state regulators
can forfeit an accountant's license based on a waived
injunction.
The Act's provision, in Section 101, for the membership
of said Board has yet to be fleshed out. Appointed to fiveyear terms, two of the members must be - or have been certified public accountants, and the remaining three must
not be and cannot have been CPAs. Lawyers are the
likeliest to be appointed to these other seats. The
Chairmanship may be held by one of the CPA members,
provided that he or she has not been engaged as a
practicing CPA for five years, meaning, ab initio, that he
or she will be behind the practice curb at a time when
change is rapid.
No Board member may, during their service on the Board,

"share in any of the profits of, or receive payments from, a
public accounting firm," other than "fixed continuing
payments," such as retirement payments. This mirrors
SEC practice with the securities industry, but does little to
tackle "the revolving door".
The Board members are appointed by the SEC, "after
consultation with" the Federal Reserve Board Chairman
and the Treasury Secretary. Given the term lengths, it is
safe to predict that every new presidential administration
will bring with it a new Board.
The major powers granted to the Board will effectively
change the accounting profession in the USA, at least with
regards to public companies, from a self-regulatory body
licensed by the states, into a national regulator.
Under Act Section 103, the Board shall: (1) register public
accounting firms; (2) establish "auditing, quality control,
ethics, independence, and other standards relating to the
preparation of audit reports for issuers;" (3) inspect
accounting firms; and (4) investigate and discipline firms
to enforce compliance with the Act, the Rules,
professional standards and the federal securities
laws. This is a sea change in the US.
As to professional standards, the Board must "cooperate
on an on-going basis" with certain accountants advisory
groups. Yet, US federal government Boards do not "co-

operate" - they dictate. The Board can "to the extent that it
determines appropriate" adopt proposals by such groups.
More importantly, it has authority to reject any standards
proffered by said groups. This will then be reviewed by
the SEC, because the Board must report on its standards to
the Commission every year. The SEC may â&#x20AC;&#x201C; by rule â&#x20AC;&#x201C;
require the Board to cover additional ground. The Board,
and the SEC through the Board, now run the US
accounting profession.
The Board is also augments the US effort to establish
hegemony over the global practice of accounting. Act
Section 106, Foreign Public Accounting Firms, subjects
foreigners who audit U.S. companies - including foreign
firms that perform audit work that is used by the primary
auditor on a foreign subsidiary of a U.S. company - to
registration with the Board.
I am amazed that the EU was silent on this inroad to their
sovereignty. This may prove more problematic in US
operations in China. I do not think the US can force its
accounting standards on China without negatively
affecting our trade there.
Under Act Section 108, the SEC now decides what are
"generally" accepted accounting principles. Registered
public accounting firms are barred from providing certain
non-audit services to an issuer they audit. Thus, the split,

first proposed by the head of Arthur Anderson in 1974, is
now the law.
Act Section 203, Audit Partner Rotation, is a gift to the
accounting profession. The lead audit or coordinating
partner and the reviewing partner must rotate every 5
years. That means that by law, the work will be spread
around. Note that the law says "partner", not
"partnership". Thus, we are likely to continue to see
institutional clients serviced by "juntas" at accounting
firms, not by individuals. This will likely end forever the
days when a single person controlled major amounts of
business at an accounting firm. US law firms would never
countenance such a change, as the competition for major
clients is intense.
Act Section 209, Consideration by Appropriate State
Regulatory Authorities, "throws a bone" to the states. It
requires state regulators to make an independent
determination whether Board standards apply to small and
mid-size non-registered accounting firms. No one can
seriously doubt the outcome of these determinations. But
we now pretend that we still have real state regulation of
the accounting profession, just as we pretend that we have
state regulation of the securities markets through "blue
sky laws". The reality is that the states will be confined
hence to the initial admission of persons to the accounting
profession. Like the "blue sky laws", it will be a revenue

source, but the states will be completely junior to the
Board and the SEC.
Act Section 302, Corporate Responsibility For Financial
Reports, mandates that the CEO and CFO of each issuer
shall certify the "appropriateness of the financial
statements and disclosures contained in the periodic
report, and that those financial statements and disclosures
fairly present, in all material respects, the operations and
financial condition of the issuer". This may prove
problematic with global companies. We have already seen
resistance by Daimler-Benz of Germany.
Act Section 305: Officer And Director Bars And
Penalties; Equitable Relief, will be used by the SEC to
counterattack arguments arising out of the Central Bank
case. As I maintained in the American Journal of Trial
Advocacy, the real significance of the Supreme Court
decision in Central Bank was that the remedial sanctions
of the federal securities laws should be narrowly
construed.
Well, now the SEC has a Congressional mandate. Federal
courts are authorized to "grant any equitable relief that
may be appropriate or necessary for the benefit of
investors". That is an incredibly broad delegation of
rights, and is an end run around Central Bank. I was
surprised that this received no publicity.

Lastly, Act Section 402, Prohibition on Personal Loans
to Executives, shows how low this generation of US
leadership has sunk. President Bush has signed a law that
makes illegal the type of loans from which he and his
extended family have previously benefited.
Tacitly, the Act admits that some practices of Enron were
not illegal inter se. Act Section 401, Study and Report on
Special Purpose Entities, provides that the SEC should
study off-balance sheet disclosures to determine their
extent and whether they are reported in a sufficiently
transparent fashion. The answer will almost certainly be
no, and the Board will change GAAP accordingly.
Q. Does the SEC collaborate with other financial
regulators and law enforcement agencies internationally?
Does it share information with other US law enforcement
agencies? Is there interagency rivalry and does it hamper
investigations? Can you give us an example?
A. The SEC and other regulators - as well as two House
subcommittees - have only very recently begun
considering information sharing between financial
regulators.
This comes too late for the victims of Martin Frankel,
who, having been barred for life from the securities
industry by the SEC and NASD in 1992, simply moved
over to the insurance industry to perpetrate a scam where
investors have lost an estimated $200 million dollars.

Had the state insurance regulators known this person's
background, he would have been unable to set up multiple
insurance companies. Failure to share information is a
genuine problem, but "turf" considerations generally
trump any joint efforts.

Return

Privatizing with Golden Shares
Written March 2002
Updated July 2005
In a rare accord, both the IMF and independent analysts,
have cautioned Bulgaria in early 2002 that its insistence
on keeping golden shares in both its tobacco and telecom
monopolies even after they are privatized - will hinder its
ability to attract foreign investors to these already
unappealing assets. Bulgaria's $300 million arrangement
with the IMF - struck in late 2001 by the new and
youthful Minister of Finance in the Saxe-Coburg
government - was not at risk, though.
Golden shares are usually retained by the state in
infrastructure projects, utilities, natural monopolies,
mining operations, defense contractors, and the space
industry. They allow their holders to block business
moves and counter management decisions which may be
detrimental to national security, to the economy, or to the
provision of public services (especially where markets fail
to do so). Golden shares also enable the government to
regulate the prices of certain basic goods and services such as energy, food staples, sewage, and water.
But, in practice, golden shares serve less noble ends.
Early privatizations in Central and Eastern Europe were
criticized for being crony-ridden, corrupt, and opaque.
Governments were accused of giving away the family
silver. Maintaining golden shares in privatized enterprises

was their way of eating the privatization cake while
leaving it whole, thus silencing domestic opposition
effectively. The practice was started in Thatcherite Britain
and Bulgaria is only the latest to adopt it.
The Bulgarian golden share in Bulgatabak is intended to
shield domestic tobacco growers (most of them
impoverished minority Turks) from fierce foreign
competition in a glutted market. Golden shares are often
used to further the interests of interest groups and isolate
them from the potentially devastating effects of the global
market.
The phenomenon of golden shares is not confined to
economically-challenged states selling their obscure
monopolies.
On December 1989, the Hungarian Post was succeeded by
three firms (postal, broadcasting, and a telecom). One of
the successors, MATAV, was sold to MagyarCom
(currently owned by Deutsche Telekom) in stages. This
has been the largest privatization in Hungary and in
Central and Eastern Europe. The company's shares
subsequently traded in Budapest and on NYSE
simultaneously. MATAV embarked on an aggressive
regional acquisitions plan, the latest of which was the
Macedonian Telecom. Yet, throughout this distinctly
capitalistic and shareholders-friendly record, the
Hungarian government owned a golden share in MATAV.
Poland's Treasury maintains a golden share in LOT, its
national carrier, and is known to have occasionally
exercised it. Lithuania kept a golden share in its telecom.
Even municipalities and regional authorities are emulating
the centre. The city of Tallinn, for instance, owns a golden
share in its water utility.

Hungary's largest firm, Hungarian Oil and Gas (MOL),
was floated on the Budapest Stock Exchange (19941998). The state retains a "golden share" in the company
which allows it to regulate retail gas prices. MOL controls
c. 35% of the fuel retail market and owns virtually all the
energy-related infrastructure in Hungary. It is an
aggressive regional player, having recently bought
Slovnaft, the Slovak oil and gas company. Theoretically,
Hungary's golden share in MOL may conflict with
Slovakia's golden share in Slovnaft, owned by MOL.
Contrary to popular economic thinking, golden shares do
not seem to deter foreign investors. They may even create
a moral hazard, causing investors to believe that they are
partners with the government in an enterprise of vital
importance and, thus, likely to be bailed out (i.e., an
implicit state guarantee).
Moreover, golden shares are often perceived by investors
and financial institutions as endowing the company with
preference in government procurement and investment,
privileged access to decision makers, concessionary terms
of operation, and a favorable pricing structure. Golden
shares are often coupled with guaranteed periods of
monopoly or duopoly (i.e., periods of excess profits and
rents).
The West, alas, is in no position to preach free marketry in
this case. European firms are notorious for the ingenious
stratagems with which they disenfranchise their
shareholders. Privileged minorities often secure the
majority vote by owning golden shares (this is especially
egregious in the Netherlands and France).
The European Commission is investigating cases of abuse
of golden shares in the UK, Spain, Portugal, Germany,

France, and Belgium. The Spanish government possesses
golden shares in companies it no longer has a stake in. As
American portfolio investors pile in, corporate governance
is changing for the better. But some countries of the
former Soviet Bloc (such as Estonia) are even more
advanced than the rest of the European Union.
Return

The Future of the Accounting Profession
Interview with David Jones
Written August 2002
Updated June 2005
On May 31, 2005, the US Supreme Court overturned the
conviction of accounting firm Arthur Anderson on charges
related to its handling of the books of the now defunct
energy concern, Enron. It was only the latest scene in a
drama which unfolded at the height of the wave of
corporate malfeasance in the USA.
David C. Jones is a part-time research fellow at the Center
for Urban Development Studies of the Graduate School of
Design, Harvard University. He has been associated with
the University since 1987 when he retired from the World
Bank, where he served as financial adviser for water
supply and urban development.
He had joined the World Bank, as a senior financial
analyst, in 1970, after working as a technical assistance
advisor for the British Government in East Africa. He
began his career in British local government. He is a
Chartered Public Finance Accountant and a Chartered
Certified Accountant (UK). He is the author of "Municipal
Accounting for Developing Countries" originally
published by the World Bank and the Chartered Institute
of Public Finance and Accountancy (UK) in 1982.
Q: Accounting scandals seem to form the core of
corporate malfeasance in the USA. Is there something

wrong with the GAAP - or with American accountants?
A: Accounting is based on some fundamental principles.
As I say at the beginning of my textbook, the accountant
"records and interprets variations in financial position ...
during any period of time, at the end of which he can
balance net results (of past operations) against net
resources (available for future operations)".
Accountancy includes the designing of financial records,
the recording of financial information based on actual
financial transactions (i.e., bookkeeping), the production
of financial statements from the recorded information,
giving advice on financial matters, and interpreting and
using financial data to assist in making the best
management decisions.
Simple as these principles may sound, they are, in
practice, rather complicated to implement, to interpret and
to practice. About 80% of the transactions require only
about 20% of the effort because they are straightforward
and obvious to a book-keeper, once the rules are learned.
But - and it is a big but - the other 20% or so of
transactions require 80% of the intellectual effort. These
transactions are most likely to have major impacts on the
profit and loss account and the balance sheet.
My colleagues and I, all qualified accountants, have
heated discussion over something as simple as the
definition of a debit or a credit. Debits can be records of
either expenses or assets. The former counts against
income in the statement of profit and loss. The latter is
treated as a continuing resource in a balance sheet. It is
sometimes gradually allocated (expensed) against income
in subsequent years, sometimes not.

A fundamental problem with the financial reporting of
WorldCom, for example, was that huge quantities of
expenses were misallocated in the accounts as assets.
Thus, by reducing expenditures, profit appeared to be
increased. The effect of this on stock values and, thereby,
on executive rewards are secondary and tertiary outcomes
not caused directly by the accountancy.
Another example concerns interest on loans that may have
been raised to finance capital investment, while a large
asset is under construction, often for several years.
Some argue that the interest should be accounted for as
part of the capital cost until the asset is operational. Others
claim that because the interest is an expense, it should be
charged against that year's profits. Yet, the current year's
income includes none of the income generated by the new
asset, so profit is under-stated. And what if a hydroelectric power station starts to operate three of its ten
turbines while still under construction? How does one
allocate what costs, as expenses or assets, in such cases?
Interestingly, the Generally Accepted Accounting
Principles (GAAP) require that "interest during
construction" be capitalized, that is included in the cost of
the asset. The International Accounting Standards (IAS)
prefer expensing but allow capitalization. From an
economic viewpoint, both are wrong - or only partially
right!
The accountancy profession should get together to
establish common practices for comparing companies,
limiting the scope for judgment. Accountants used to
make the rules in the USA and elsewhere until the
business community demanded input from other
professionals, to provide a more "balanced" view.

This led to the establishment of the Financial Accounting
Standards Board (FASB), with non-accountants as
members. The GAAP has been tempered by political and
business lobbying. Moreover, accounting rules for
taxation purposes and applied to companies quoted on
stock exchanges are not always consistent with the GAAP.
Accountants who do not follow the rules are disciplined.
American accountants are among the best educated and
best-trained in the world. Those who wish to be
recognized as auditors of significant enterprises must be
CPAs. Thus, they must have obtained at least a financerelated bachelor's degree and then have passed a five-part
examination that is commonly set, nation-wide, by the
American Institute of Certified Public Accountants
(AICPA). To practice publicly, they must be licensed by
the state in which they live or practice. To remain a CPA,
each must abide by the standards of conduct and ethics of
the AICPA, including a requirement for continuing
professional education.
Most other countries have comparable rules. Probably the
closest comparisons to the USA are found in the UK and
its former colonies.
Q: Can you briefly compare the advantages and
disadvantages of the GAAP and the IAS?
A: It is asserted that the GAAP tend to be "rule-based"
and the IAS are "principle-based." GAAP, because they
are founded on the business environment of the USA are
closely aligned to its laws and regulations. The IAS seek
to prescribe how credible accounting practices can operate
within a country's existing legal structure and prevailing
business practices.

Alas, sometimes the IAS and the GAAP are in
disagreement. The two rule-making bodies - FASB and
IASB - are trying to cooperate to eliminate such
differences.
The Inter-American Development Bank, having reviewed
the situation in Latin America, concluded that most of the
countries in that region - as well as Canada and the EU
aspirants - are IAS-orientated. Still, the USA is by far the
largest economy in the world, with significant political
influence. It also has the world's most important financial
markets.
Q: Can accounting cope with derivatives, off-shore
entities, stock options - or is there a problem in the very
effort to capture dynamics and uncertainties in terms of a
static, numerical representation?
A: Most, if not all, of these matters can be handled by
proper application of accounting principles and practices.
Much has been made of expensing employee stock
options, for instance. But an FASB proposal in the early
nineties was watered down at the insistence of US
company lobbyists and legislators.
How to value stock options and when to recognize them is
not clear. A paper on the topic identified sixteen different
valuation parameters. But accountants are accustomed to
dealing with such practical matters.
Q: Can you describe the state of the art (i.e., recent
trends) of municipal finance in the USA, Europe, Latin
America (mainly Argentina and Brazil), and in emerging
economies (e.g., central and eastern Europe)?
A: There are no standard practices for governmental
accounting - whether national, federal, state, or local. The

International Federation of Accountants (IFAC) urged
accountants to follow various practices. It subsequently
settled mainly on accrual accounting standards.
Some countries - the UK, for local government, New
Zealand for both central and local government - use full
accrual at current value, which is beyond many private
sector practices. This is being reviewed in the UK. The
central government there is introducing "resource-based"
accounting, approximating full accrual at current value.
The US Governmental Accounting Standards Board has
recently recommended that US local governments
produce dual financial reports, combining "commerciallybased" practices with those emanating from the truly
unique US "fund accounting" system.
In my book I recognized that fixed assets are being funded
less and less entirely by debt, private sector accounting
practices increasingly intrude into the public sector, and
costs of services must be much more carefully assessed.
Q: Are we likely to witness municipal Enrons and
World.com's?
A: We already have! Remember the financial downfall
and restructuring of New York City in the seventies. Other
state and local governments have had serious defaults in
USA and elsewhere. Shortcomings of their accounting,
politicians choosing to ignore predictive budgeting,
borrowing used to cover operating expenditures - similar
to WorldCom. In the case of the New York City debacle,
operating expenditures were treated as capital
expenditures to balance the operating budget.
More recently, I testified to the US Congress about
Washington DC, where the City Council ran up a huge

accumulated operating deficit, of c. $700 million. It then
sought Congressional approval to cover this deficit by
borrowing.
Even more recently, the State of Virginia decided to
abolish the property tax on domestic vehicles. This left a
huge gap in the following year's current budget. The
governor proposed to use a deceptive accounting device
and to set up a separate - and, thus not subject to a
referendum - "revenue" bond-issuing entity (shades of
Enron's "Special Purpose Entities"). The bonds were then
to be serviced by expected annual receipts from the
negotiated tobacco settlement, at that time not even
finalized. This crazy and illegal plan was abandoned.
The fact that both accounting and financial reporting for
local governments are very often in slightly modified
cash-based formats adds to the confusion. But these
formats could be built on. Indeed, in the very tight
budgetary situations facing virtually every local
government, it is essential that cash management on a dayto-day basis be given high priority.
Still, the system can be misleading. It produces extremely
scant information on costs - the use of resources - compared
with expenditures (i.e., cash-flows). More seriously, cash
accounting allows indiscriminate allocation of funds
between capital and recurrent purposes, thus permitting no
useful assessment of annual or other periodic financial
performance.
A cash-based system cannot engender a credible balance
sheet. It produces meaningless and incoherent information
on assets and liabilities and the ownership, or trusteeship, of
separate (or separable) funds. It is not a sound system of
budgetary control. When year-end unpaid invoices are held

over, it creates a false impression of operating within
approved budgetary limits. Thus, local government units
can run serious budgetary deficits that are hidden from
public view merely by not paying their bills on time and
in full! A cash accounting system will not reveal this.
Still, moving to an accrual system should be done slowly
and cautiously. Private sector experience, in former Soviet
countries, of changing to accrual accounting was
administratively traumatic. Their public sector systems
may not easily survive any major tinkering, let alone an eventually inevitable - full overhaul. Skills, tools, and
access to proper professional knowledge are required
before this is attempted.
Q: Can you compare municipal and corporate accounting
and financing practices as far as governance and control
are concerned?
A: In corporate accounting practice, the notional owners
and managers are the shareholders. In practice, through
the use of proxies and other devices, the real control is
normally in the hands of a board of directors. Actual day
to day control reverts to the company chairmen, president,
chief executive or chief operating officer. The chief
financial officer is often - though not necessarily - an
accountant and he or she oversees qualified accountants.
The company's accountants must produce the annual and
other financial statements. It is not the responsibility of
the auditors whose obligation is to report to the
shareholders on the credibility and legality of the financial
statements. The shareholders may appoint an audit
committee to review the audit reports on their behalf. The
audit is carried out by Certified Public Accountants with
recognized accounting credentials. Both the qualified

accountants in the audit firm and those in the corporation
are subject to professional discipline of their accounting
institutions and of the law.
In local government accounting practice, the public
trustees and managers are normally a locally elected
council. Often, the detailed control over financial
management is in the hands of a finance committee or
finance commission, usually comprised only of elected
members.
Traditionally, only the elected council may take major
financial decisions, such as approving a budget, levying
taxes and borrowing. Actual day to day control of a local
government may be by an executive mayor, or by an
elected or appointed chief executive. There normally is a
chief financial officer, often - though not necessarily - an
accountant in charge of other qualified accountants.
It is the responsibility of the accountants of the local
government to produce the annual and other financial
statements. It is not the responsibility of the auditors
whose obligation is to report to the local elected council
on the credibility and legality of the financial statements.
The council may appoint an audit committee to review the
audit reports on their behalf, or they may ask the finance
committee to do this.
However, it is quite common, in many countries, for local
government financial statements to be audited by properly
authorized public officials. Auditors should be qualified,
independent, experienced, and competent. Audits should
be regular and comprehensive. It is unclear whether or not
public official auditors always fulfill these conditions.
In the United Kingdom, for example, there is a Local

Government Audit Commission which employs qualified
accountants either on its own staff or from hired
accountancy firms. Thus, it clearly follows high standards.
Q: How did the worldwide trend of devolution affect
municipal finance?
A: Outside of the former Soviet Union and Eastern
Europe, municipal finance was not significantly affected
by devolution, though there has been a tendency for
decentralization. Central governments hold the pursestrings and almost all local governments operate under
legislation engendered by the national, or - in federal
systems - state, governments. Local governments rarely
have separate constitutional authority, although there are
varying degrees of local autonomy.
In the former Soviet Empire, changes of systems and of
attitudes were much more dramatic. Local government
units, unlike under the former Soviet system, are not
branches of the general government. They are separate
corporate bodies, or legal persons. But in Russia, and in
other former socialist countries, they have often been
granted "de jure" (legal) independence but not full "de
facto" (practical) autonomy.
There seems to be an unwillingness to accept that the two
systems are intended to operate quite differently. What is
good for a central government is not necessarily equally
good for a local government unit. For example, the main
purpose of local government is to provide public services,
with only enough authority to perform them effectively. It
is almost always the responsibility of a central or state
government to enact and enforce the criminal and civil
law. Local by-laws or ordinances are usually concerned
only with minor matters and are subject to an enabling

legislation. Moreover, they may prove to be "ultra vires"
(beyond their powers) and, therefore, unconstitutional, or
at least unenforceable.
It may be appropriate, under certain circumstances, for a
central government to run budgetary deficits, whether
caused by current or capital transactions. In local
government units, there is almost always a necessity to
distinguish between such transactions. Moreover, in most
countries, local government units are required by law to
have balanced budgets, without resort to borrowing to
cover current deficits.
A corporate body (legal person), whether a private or a
public sector entity, has a separate legal identity from the
central government and from the members, shareholders, or
electorate who own and manage it. It has its own corporate
name. Typically, its formal decisions are by resolution of its
managing body (board or council). Written documents are
authenticated by its common seal. It may contract, sue and
be sued in its own name. Indeed, unless specifically
prevented by law, it may even sue the central government!
It may also have legal relationships with its own individual
members or with its staff. It is often said to have perpetual
succession, meaning that it lives on, even though the
individual members may die, resign or otherwise cease their
membership.
While a corporation owes its existence to legislation, a
local government unit is established, typically, under
something like a "Local Government Organic Law".
Corporate status differs fundamentally from that of (say)
government departments in a system of de-concentration.
Permanent closure or abolition of a municipal council, or
indeed any change in its powers and duties, would almost
always require formal legal action, typically national

parliamentary legislation.
A local government unit makes its own policy decisions,
some of which, especially the financial ones, often require
approval by a central government authority. Still, the central
government rarely runs, or manages, a local government
unit on a daily basis. The relationship is at arms length and
not hands on. A local government unit usually is
empowered to own land and real estate. Sometimes, public
assets - such as with roads or drainage systems - are deemed
to be "vested in" the local authority because they cannot be
owned in the same way as buildings are.
Q: Local authorities issue bonds, partake in joint ventures,
lend to SME's - in short, encroach on turf previously
exclusively occupied by banks, the capital markets, and
business. Is this a good or a bad thing?
A: Local governments are established to provide services
and perform activities required or allowed by law!
Normally, they won't seek or be permitted to engage in
commercial activities, best left to the private sector.
However, there have always been natural monopolies
(such as water supply), coping with negative economic
externalities (such as sewerage and solid waste
management), the provision of whole or partial public
goods (such as street lighting, or roads) and merit goods
(such as education, health, and welfare), and services that
the community, for economic or social reasons, seeks to
subsidize (such as urban transport). Left to the private
marketplace, these services would be absent, or undersupplied, or over-charged for.
Such services are wholly or partially financed by local
taxation, either imposed by local governments, or by
central (or state) taxation, through a grant or revenue-

sharing system. What has changed in recent years is that
local governments have been encouraged and empowered
to outsource these services to the private sector, or to
"public-private" partnerships.
Charges for services, and revenues from taxation cover
current operating expenditures with a small operating
surplus used to partly fund capital expenditure or to
service long, or medium term debt, such as bond issues
secured against future revenues. Commercial banks,
because of their tendency to lend only for relatively short
periods of time, usually have a relatively minor role in
such funding, except perhaps as fiscal agents or bond
issue managers.
Other funding is obtained via direct - and dependenceforming - capital grants from the central or state
government. Alternatively, the central government can
establish a quasi-autonomous local government loans
authority, which it may wholly or partially fund. The
authority may also seek to raise additional funds from
commercial sources and make loans on reasonable terms
to the local governments.
Third, the central government may lend directly to local
governments, or guarantee their borrowing. Finally, local
governments are left to their own devices to raise loans as
and when they can, on whatever terms are available. This
usually leaves them in a precarious position, because the
market for this kind of long and medium term credit is
thin and costly.
Commercial banks make short term loans to local
governments to cover temporary shortages of working
capital. If not properly controlled, such short-term loans
are rolled over and accumulate unsustainably. That is what

happed in New York City, in the seventies.
Q: In the age of the Internet and the car, isn't the added
layer of municipal bureaucracy superfluous or even
counterproductive? Can't the center - at least in smallish
countries - administer things at least as well?
A: I am quite sure that they can. There are many glaring
examples of mismatches of sizes, shapes and
responsibilities of local government units. For example,
New York, Moscow and Bombay are each single local
government units. Yet, they each have much bigger
populations than many countries, such as New Zealand,
the republics of former Yugoslavia, and the Baltic states.
On the other hand, the Greater Washington Metropolitan
Area comprises a federal district, four counties and
several small cities. The local government systems are
under the jurisdictions of two states and the federal
government. Each of the two states has a completely
different traditions and systems of local governance,
emanating from pre-independence times. Accordingly, the
local government systems north and east of the Potomac
River (which flows through the Washington area) are
substantially different from those to the south and west.
Finally, the Boston area, a cradle of U.S. democracy, is
governed by a conglomerate of over 40 local government
jurisdictions. Even its most famous college, Harvard, is in
Cambridge and not in Boston itself. Many of the
jurisdictions are so small (Boston is not very big by U.S.
standards) that common services are run by agencies of
the State of Massachusetts.
The problem of centralizing financial records would,
indeed, be relatively simple to solve. If credit card
companies can maintain linkages world-wide, there is no

practical reason why local government accounts for (say)
a city in Macedonia could not be kept in China. The issue
here is quite different. It revolves around democracy,
tradition, living in community, service delivery at a local
level, civil society, and the common wealth. It really has
very little to do with accountancy, which is just one tool
of management, albeit an important one.

Return

The Economics of Expectations
Economies revolve around and are determined by
"anchors": stores of value that assume pivotal roles and
lend character to transactions and economic players alike.
Well into the 19 century, tangible assets such as real estate
and commodities constituted the bulk of the exchanges
that occurred in marketplaces, both national and global.
People bought and sold land, buildings, minerals, edibles,
and capital goods. These were regarded not merely as
means of production but also as forms of wealth.
Inevitably, human society organized itself to facilitate
such exchanges. The legal and political systems sought to
support, encourage, and catalyze transactions by
enhancing and enforcing property rights, by providing
public goods, and by rectifying market failures.
Later on and well into the 1980s, symbolic representations
of ownership of real goods and property (e.g, shares,
commercial paper, collateralized bonds, forward
contracts) were all the rage. By the end of this period,
these surpassed the size of markets in underlying assets.
Thus, the daily turnover in stocks, bonds, and currencies
dwarfed the annual value added in all industries
combined.
Again, Mankind adapted to this new environment.
Technology catered to the needs of traders and
speculators, businessmen and middlemen. Advances in
telecommunications
and
transportation
followed
inexorably. The concept of intellectual property rights was

introduced. A financial infrastructure emerged, replete
with highly specialized institutions (e.g., central banks)
and businesses (for instance, investment banks, jobbers,
and private equity funds).
We are in the throes of a third wave. Instead of buying and
selling assets one way (as tangibles) or the other (as
symbols) - we increasingly trade in expectations (in other
words, we transfer risks). The markets in derivatives
(options, futures, indices, swaps, collateralized
instruments, and so on) are flourishing.
Society is never far behind. Even the most conservative
economic structures and institutions now strive to manage
expectations. Thus, for example, rather than tackle
inflation directly, central banks currently seek to subdue it
by issuing inflation targets (in other words, they aim to
influence public expectations regarding future inflation).
The more abstract the item traded, the less cumbersome it
is and the more frictionless the exchanges in which it is
swapped. The smooth transmission of information gives
rise to both positive and negative outcomes: more efficient
markets, on the one hand - and contagion on the other
hand; less volatility on the one hand - and swifter
reactions to bad news on the other hand (hence the need
for market breakers); the immediate incorporation of new
data in prices on the one hand - and asset bubbles on the
other hand.
Hitherto, even the most arcane and abstract contract
traded was somehow attached to and derived from an
underlying tangible asset, no matter how remotely. But
this linkage may soon be dispensed with. The future may
witness the bartering of agreements that have nothing to
do with real world objects or values.

In days to come, traders and speculators will be able to
generate on the fly their own, custom-made, one-time,
investment vehicles for each and every specific
transaction. They will do so by combining "off-the-shelf",
publicly traded components. Gains and losses will be
determined by arbitrary rules or by reference to
extraneous events. Real estate, commodities, and capital
goods will revert to their original forms and functions:
bare necessities to be utilized and consumed, not
speculated on.
Note: Why Recessions Happen and How to Counter
Them
The fate of modern economies is determined by four types
of demand: the demand for consumer goods; the demand
for investment goods; the demand for money; and the
demand for assets, which represent the expected utility of
money (deferred money).
Periods of economic boom are characterized by a
heightened demand for goods, both consumer and
investment; a rising demand for assets; and low demand
for actual money (low savings, low capitalization, high
leverage).
Investment booms foster excesses (for instance: excess
capacity) that, invariably lead to investment busts. But,
economy-wide recessions are not triggered exclusively
and merely by investment busts. They are the outcomes of
a shift in sentiment: a rising demand for money at the
expense of the demand for goods and assets.
In other words, a recession is brought about when people
start to rid themselves of assets (and, in the process,
deleverage); when they consume and lend less and save

more; and when they invest less and hire fewer workers. A
newfound predilection for cash and cash-equivalents is a
surefire sign of impending and imminent economic
collapse.
This etiology indicates the cure: reflation. Printing money
and increasing the money supply are bound to have
inflationary effects. Inflation ought to reduce the public's
appetite for a depreciating currency and push individuals,
firms, and banks to invest in goods and assets and reboot
the economy. Government funds can also be used directly
to consume and invest, although the impact of such
interventions is far from certain.
Also Read
Governments and Growth
The Dismal Mind - Economics as a Pretension to
Science
Economics - The Neglected Branch of Psychology
The Fabric of Economic Trust
The Distributive Justice of the Market
Scavenger Economies and Predator Economies
Notes on the Economics of Game Theory
Knowledge and Power
The Disruptive Engine - Innovation and the Capitalist
Dream
The Spectrum of Auctions

Market Impeders and Market Inefficiencies
Moral Hazard the Survival Value of Risk
The Myth of the Earnings Yield
The Principal-Agent Conundrum
Trading in Sovereign Promises

Return

Anarchy as an Organizing Principle
The recent spate of accounting fraud scandals signals the
end of an era. Disillusionment and disenchantment with
American capitalism may yet lead to a tectonic
ideological shift from laissez faire and self regulation to
state intervention and regulation. This would be the
reversal of a trend dating back to Thatcher in Britain and
Reagan in the USA. It would also cast some fundamental and way more ancient - tenets of free-marketry in grave
doubt.
Markets are perceived as self-organizing, self-assembling,
exchanges of information, goods, and services. Adam
Smith's "invisible hand" is the sum of all the mechanisms
whose interaction gives rise to the optimal allocation of
economic resources. The market's great advantages over
central planning are precisely its randomness and its lack
of self-awareness.
Market participants go about their egoistic business,
trying to maximize their utility, oblivious of the interests
and action of all, bar those they interact with directly.
Somehow, out of the chaos and clamor, a structure
emerges of order and efficiency unmatched. Man is
incapable of intentionally producing better outcomes.
Thus, any intervention and interference are deemed to be
detrimental to the proper functioning of the economy.
It is a minor step from this idealized worldview back to
the Physiocrats, who preceded Adam Smith, and who
propounded the doctrine of "laissez faire, laissez passer" -

the hands-off battle cry. Theirs was a natural religion. The
market, as an agglomeration of individuals, they
thundered, was surely entitled to enjoy the rights and
freedoms accorded to each and every person. John Stuart
Mill weighed against the state's involvement in the
economy in his influential and exquisitely-timed
"Principles of Political Economy", published in 1848.
Undaunted by mounting evidence of market failures - for
instance to provide affordable and plentiful public goods this flawed theory returned with a vengeance in the last
two decades of the past century. Privatization,
deregulation, and self-regulation became faddish
buzzwords and part of a global consensus propagated by
both commercial banks and multilateral lenders.
As applied to the professions - to accountants, stock
brokers, lawyers, bankers, insurers, and so on - selfregulation was premised on the belief in long-term selfpreservation. Rational economic players and moral agents
are supposed to maximize their utility in the long-run by
observing the rules and regulations of a level playing
field.
This noble propensity seemed, alas, to have been
tampered by avarice and narcissism and by the immature
inability to postpone gratification. Self-regulation failed
so spectacularly to conquer human nature that its demise
gave rise to the most intrusive statal stratagems ever
devised. In both the UK and the USA, the government is
much more heavily and pervasively involved in the
minutia of accountancy, stock dealing, and banking than it
was only two years ago.
But the ethos and myth of "order out of chaos" - with its
proponents in the exact sciences as well - ran deeper than

that. The very culture of commerce was thoroughly
permeated and transformed. It is not surprising that the
Internet - a chaotic network with an anarchic modus
operandi - flourished at these times.
The dotcom revolution was less about technology than
about new ways of doing business - mixing umpteen
irreconcilable ingredients, stirring well, and hoping for the
best. No one, for instance, offered a linear revenue model
of how to translate "eyeballs" - i.e., the number of visitors
to a Web site - to money ("monetizing"). It was
dogmatically held to be true that, miraculously, traffic - a
chaotic phenomenon - will translate to profit - hitherto the
outcome of painstaking labour.
Privatization itself was such a leap of faith. State owned
assets - including utilities and suppliers of public goods
such as health and education - were transferred wholesale
to the hands of profit maximizers. The implicit belief was
that the price mechanism will provide the missing
planning and regulation. In other words, higher prices
were supposed to guarantee an uninterrupted service.
Predictably, failure ensued - from electricity utilities in
California to railway operators in Britain.
The simultaneous crumbling of these urban legends - the
liberating power of the Net, the self-regulating markets,
the unbridled merits of privatization - inevitably gave rise
to a backlash.
The state has acquired monstrous proportions in the
decades since the Second world War. It is about to grow
further and to digest the few sectors hitherto left
untouched. To say the least, these are not good news. But
we libertarians - proponents of both individual freedom
and individual responsibility - have brought it on

ourselves by thwarting the work of that invisible regulator
- the market.

Return

Winners of the 1997 Nobel Prize in the
Economic Sciences
The Pricing of Options
The Royal Swedish Academy of Sciences has decided to
award the 1997 Bank of Sweden Prize in Economic
Sciences in Memory of Alfred Nobel to Professor Robert
C. Merton, Harvard University, and to Professor Myron S.
Scholes, Stanford University, jointly. The prize was
awarded for a new method to determine the value of
derivatives.
This sounds like a trifle achievement - but it is not. It
touches upon the very heart of the science of Economics:
the concept of Risk. Risk reflects the effect on the value of
an asset where there is an option to change it (the value)
in the future.
We could be talking about a physical assets or a nontangible asset, such as a contract between two parties. An
asset is also an investment, an insurance policy, a bank
guarantee and any other form of contingent liability,
corporate or not.
Scholes himself said that his formula is good for any
situation involving a contract whose value depends on the
(uncertain) future value of an asset.
The discipline of risk management is relatively old. As
early as 200 years ago households and firms were able to
defray their risk and to maintain a level of risk acceptable
to them by redistributing risks towards other agents who
were willing and able to assume them. In the financial

markets this is done by using derivative securities options,
futures and others. Futures and forwards hedge against
future (potential - all risks are potentials) risks. These are
contracts which promise a future delivery of a certain item
at a certain price no later than a given date. Firms can thus
sell their future production (agricultural produce,
minerals) in advance at the futures market specific to their
goods. The risk of future price movements is re-allocated,
this way, from the producer or manufacturer to the buyer
of the contract. Options are designed to hedge against
one-sided risks; they represent the right, but not the
obligation, to buy or sell something at a pre-determined
price in the future. An importer that has to make a large
payment in a foreign currency can suffer large losses due
to a future depreciation of his domestic currency. He can
avoid these losses by buying call options for the foreign
currency on the market for foreign currency options (and,
obviously, pay the correct price for them).
Fischer Black, Robert Merton and Myron Scholes
developed a method of correctly pricing derivatives. Their
work in the early 1970s proposed a solution to a crucial
problem in financing theory: what is the best (=correctly
or minimally priced) way of dealing with financial risk. It
was this solution which brought about the rapid growth of
markets for derivatives in the last two decades. Fischer
Black died in August 1995, in his early fifties. Had he
lived longer, he most definitely would have shared the
Nobel Prize.
Black, Merton and Scholes can be applied to a number of
economic contracts and decisions which can be construed
as options. Any investment may provide opportunities
(options) to expand into new markets in the future. Their
methodology can be used to value things as diverse as

investments, insurance policies and guarantees.
Valuing Financial Options
One of the earliest efforts to determine the value of stock
options was made by Louis Bachelier in his Ph.D. thesis
at the Sorbonne in 1900. His formula was based on
unrealistic assumptions such as a zero interest rate and
negative share prices.
Still, scholars like Case Sprenkle, James Boness and Paul
Samuelson used his formula. They introduced several now
universally accepted assumptions: that stock prices are
normally distributed (which guarantees that share prices
are positive), a non-zero (negative or positive) interest
rate, the risk aversion of investors, the existence of a risk
premium (on top of the risk-free interest rate). In 1964,
Boness came up with a formula which was very similar to
the Black-Scholes formula. Yet, it still incorporated
compensation for the risk associated with a stock through
an unknown interest rate.
Prior to 1973, people discounted (capitalized) the
expected value of a stock option at expiration. They used
arbitrary risk premiums in the discounting process. The
risk premium represented the volatility of the underlying
stock.
In other words, it represented the chances to find the price
of the stock within a given range of prices on expiration.
It did not represent the investors' risk aversion, something
which is impossible to observe in reality.

The Black and Scholes Formula
The revolution brought about by Merton, Black and
Scholes was recognizing that it is not necessary to use any
risk premium when valuing an option because it is already
included in the price of the stock. In 1973 Fischer Black
and Myron S. Scholes published the famous option
pricing Black and Scholes formula. Merton extended it in
1973.
The idea was simple: a formula for option valuation
should determine exactly how the value of the option
depends on the current share price (professionally called
the "delta" of the option). A delta of 1 means that a $1
increase or decrease in the price of the share is translated
to a $1 identical movement in the price of the option.
An investor that holds the share and wants to protect
himself against the changes in its price can eliminate the
risk by selling (writing) options as the number of shares
he owns. If the share price increases, the investor will
make a profit on the shares which will be identical to the
losses on the options. The seller of an option incurs losses
when the share price goes up, because he has to pay
money to the people who bought it or give to them the
shares at a price that is lower than the market price - the
strike price of the option. The reverse is true for decreases
in the share price. Yet, the money received by the investor
from the buyers of the options that he sold is invested.
Altogether, the investor should receive a yield equivalent
to the yield on risk free investments (for instance, treasury
bills).
Changes in the share price and drawing nearer to the
maturity (expiration) date of the option changes the delta
of the option. The investor has to change the portfolio of

his investments (shares, sold options and the money
received from the option buyers) to account for this
changing delta.
This is the first unrealistic assumption of Black, Merton
and Scholes: that the investor can trade continuously
without any transaction costs (though others amended the
formula later).
According to their formula, the value of a call option is
given by the difference between the expected share price
and the expected cost if the option is exercised. The value
of the option is higher, the higher the current share price,
the higher the volatility of the share price (as measured by
its standard deviation), the higher the risk-free interest
rate, the longer the time to maturity, the lower the strike
price, and the higher the probability that the option will be
exercised.
All the parameters in the equation are observable except
the volatility , which has to be estimated from market
data. If the price of the call option is known, the formula
can be used to solve for the market's estimate of the share
volatility.
Merton contributed to this revolutionary thinking by
saying that to evaluate stock options, the market does not
need to be in equilibrium. It is sufficient that no arbitrage
opportunities will arise (namely, that the market will price
the share and the option correctly). So, Merton was not
afraid to include a fluctuating (stochastic) interest rate in
HIS treatment of the Black and Scholes formula.
His much more flexible approach also fitted more
complex types of options (known as synthetic options created by buying or selling two unrelated securities).

Theory and Practice
The Nobel laureates succeeded to solve a problem more
than 70 years old.
But their contribution had both theoretical and practical
importance. It assisted in solving many economic
problems, to price derivatives and to valuation in other
areas. Their method has been used to determine the value
of currency options, interest rate options, options on
futures, and so on.
Today, we no longer use the original formula. The interest
rate in modern theories is stochastic, the volatility of the
share price varies stochastically over time, prices develop
in jumps, transaction costs are taken into account and
prices can be controlled (e.g. currencies are restricted to
move inside bands in many countries).
Specific Applications of the Formula: Corporate
Liabilities
A share can be thought of as an option on the firm. If the
value of the firm is lower than the value of its maturing
debt, the shareholders have the right, but not the
obligation, to repay the loans. We can, therefore, use the
Black and Scholes to value shares, even when are not
traded. Shares are liabilities of the firm and all other
liabilities can be treated the same way.
In financial contract theory the methodology has been
used to design optimal financial contracts, taking into
account various aspects of bankruptcy law.
Investment evaluation Flexibility is a key factor in a
successful choice between investments. Let us take a
surprising example: equipment differs in its flexibility -

some equipment can be deactivated and reactivated at will
(as the market price of the product fluctuates), uses
different sources of energy with varying relative prices
(example: the relative prices of oil versus electricity), etc.
This kind of equipment is really an option: to operate or to
shut down, to use oil or electricity).
The Black and Scholes formula could help make the right
decision.
Guarantees and Insurance Contracts
Insurance policies and financial (and non financial)
guarantees can be evaluated using option-pricing theory.
Insurance against the non-payment of a debt security is
equivalent to a put option on the debt security with a
strike price that is equal to the nominal value of the
security. A real put option would provide its holder with
the right to sell the debt security if its value declines
below the strike price.
Put differently, the put option owner has the possibility to
limit his losses.
Option contracts are, indeed, a kind of insurance contracts
and the two markets are competing.

Complete Markets
Merton (1977) extended the dynamic theory of financial
markets. In the 1950s, Kenneth Arrow and Gerard Debreu
(both Nobel Prize winners) demonstrated that individuals,
households and firms can abolish their risk: if there exist
as many independent securities as there are future states of
the world (a quite large number). Merton proved that far
fewer financial instruments are sufficient to eliminate risk,
even when the number of future states is very large.
Practical Importance
Option contracts began to be traded on the Chicago Board
Options Exchange (CBOE) in April 1973, one month
before the formula was published.
It was only in 1975 that traders had begun applying it using programmed calculators. Thousands of traders and
investors use the formula daily in markets throughout the
world. In many countries, it is mandatory by law to use
the formula to price stock warrants and options. In Israel,
the formula must be included and explained in every
public offering prospectus.
Today, we cannot conceive of the financial world without
the formula.
Investment portfolio managers use put options to hedge
against a decline in share prices. Companies use
derivative instruments to fight currency, interest rates and
other financial risks. Banks and other financial institutions
use it to price (even to characterize) new products, offer
customized financial solutions and instruments to their
clients and to minimize their own risks.

Some Other Scientific Contributions
The work of Merton and Scholes was not confined to
inventing the formula.
Merton analysed individual consumption and investment
decisions in continuous time. He generalized an important
asset pricing model called the CAPM and gave it a
dynamic form. He applied option pricing formulas in
different fields.
He is most known for deriving a formula which allows
stock price movements to be discontinuous.
Scholes studied the effect of dividends on share prices and
estimated the risks associated with the share which are not
specific to it. He is a great guru of the efficient
marketplace ("The Invisible Hand of the Market").

Return

The Fabric of Economic Trust
Economics acquired its dismal reputation by pretending to
be an exact science rather than a branch of mass
psychology. In truth it is a narrative struggling to describe
the aggregate behavior of humans. It seeks to cloak its
uncertainties and shifting fashions with mathematical
formulae and elaborate econometric computerized
models.
So much is certain, though - that people operate within
markets, free or regulated, patchy or organized. They
attach numerical (and emotional) values to their inputs
(work, capital) and to their possessions (assets, natural
endowments). They communicate these values to each
other by sending out signals known as prices.
Yet, this entire edifice - the market and its price
mechanism - critically depends on trust. If people do not
trust each other, or the economic "envelope" within which
they interact - economic activity gradually grinds to a halt.
There is a strong correlation between the general level of
trust and the extent and intensity of economic activity.
Francis Fukuyama, the political scientist, distinguishes
between high-trust and prosperous societies and low-trust
and, therefore, impoverished collectives. Trust underlies
economic success, he argued in a 1995 tome.
Trust is not a monolithic quantity. There are a few
categories of economic trust. Some forms of trust are akin
to a public good and are closely related to governmental
action or inaction, the reputation of the state and its
institutions, and its pronounced agenda. Other types of
trust are the outcomes of kinship, ethnic origin, personal

standing and goodwill, corporate brands and other data
generated by individuals, households, and firms.
I. Trust in the playing field
To transact, people have to maintain faith in a relevant
economic horizon and in the immutability of the
economic playing field or "envelope". Put less obscurely,
a few hidden assumptions underlie the continued
economic activity of market players.
They assume, for instance, that the market will continue to
exist for the foreseeable future in its current form. That it
will remain inert - unhindered by externalities like
government intervention, geopolitical upheavals, crises,
abrupt changes in accounting policies and tax laws,
hyperinflation, institutional and structural reform and
other market-deflecting events and processes.
They further assume that their price signals will not be
distorted or thwarted on a consistent basis thus skewing
the efficient and rational allocation of risks and rewards.
Insider trading, stock manipulation, monopolies, hoarding
- all tend to consistently but unpredictably distort price
signals and, thus, deter market participation.
Market players take for granted the existence and
continuous operation of institutions - financial
intermediaries, law enforcement agencies, courts. It is
important to note that market players prefer continuity and
certainty to evolution, however gradual and ultimately
beneficial. A venal bureaucrat is a known quantity and can
be tackled effectively. A period of transition to good and
equitable governance can be more stifling than any level
of corruption and malfeasance. This is why economic
activity drops sharply whenever institutions are reformed.

II. Trust in other players
Market players assume that other players are (generally)
rational, that they have intentions, that they intend to
maximize their benefits and that they are likely to act on
their intentions in a legal (or rule-based), rational manner.
III. Trust in market liquidity
Market players assume that other players possess or have
access to the liquid means they need in order to act on
their intentions and obligations. They know, from personal
experience, that idle capital tends to dwindle and that the
only way to, perhaps, maintain or increase it is to transact
with others, directly or through intermediaries, such as
banks.
IV. Trust in others' knowledge and ability
Market players assume that other players possess or have
access to the intellectual property, technology, and
knowledge they need in order to realize their intentions
and obligations. This implicitly presupposes that all other
market players are physically, mentally, legally and
financially able and willing to act their parts as stipulated,
for instance, in contracts they sign.
The emotional dimensions of contracting are often
neglected in economics. Players assume that their
counterparts maintain a realistic and stable sense of selfworth based on intimate knowledge of their own strengths
and weaknesses. Market participants are presumed to
harbor realistic expectations, commensurate with their
skills and accomplishments. Allowance is made for
exaggeration, disinformation, even outright deception but these are supposed to be marginal phenomena.

When trust breaks down - often the result of an external or
internal systemic shock - people react expectedly. The
number of voluntary interactions and transactions
decreases sharply. With a collapsed investment horizon,
individuals and firms become corrupt in an effort to
shortcut their way into economic benefits, not knowing
how long will the system survive. Criminal activity
increases.
People compensate with fantasies and grandiose delusions
for their growing sense of uncertainty, helplessness, and
fears. This is a self-reinforcing mechanism, a vicious
cycle which results in under-confidence and a fluctuating
self esteem. They develop psychological defence
mechanisms.
Cognitive dissonance ("I really choose to be poor rather
than heartless"), pathological envy (seeks to deprive
others and thus gain emotional reward), rigidity ("I am
like that, my family or ethnic group has been like that for
generations, there is nothing I can do"), passiveaggressive behavior (obstructing the work flow,
absenteeism, stealing from the employer, adhering strictly
to arcane regulations) - are all reactions to a breakdown in
one or more of the four aforementioned types of trust.
Furthermore, people in a trust crisis are unable to
postpone gratification. They often become frustrated,
aggressive, and deceitful if denied. They resort to reckless
behavior and stopgap economic activities.
In economic environments with compromised and
impaired trust, loyalty decreases and mobility increases.
People switch jobs, renege on obligations, fail to repay
debts, relocate often. Concepts like exclusivity, the
sanctity of contracts, workplace loyalty, or a career path all get eroded. As a result, little is invested in the future, in
the acquisition of skills, in long term savings. Short-

termism and bottom line mentality rule.
The outcomes of a crisis of trust are, usually, catastrophic:
Economic activity is much reduced, human capital is
corroded and wasted, brain drain increases, illegal and
extra-legal activities rise, society is polarized between
haves and haves-not, interethnic and inter-racial tensions
increase. To rebuild trust in such circumstances is a
daunting task. The loss of trust is contagious and, finally,
it infects every institution and profession in the land. It is
the stuff revolutions are made of.
Return

The Distributive Justice of the Market
The public outcry against executive pay and compensation
followed disclosures of insider trading, double dealing,
and outright fraud. But even honest and productive
entrepreneurs often earn more money in one year than
Albert Einstein did in his entire life. This strikes many especially academics - as unfair. Surely Einstein's
contributions to human knowledge and welfare far exceed
anything ever accomplished by sundry businessmen?
Fortunately, this discrepancy is cause for constructive
jealousy, emulation, and imitation. It can, however, lead to
an orgy of destructive and self-ruinous envy.
Such envy is reinforced by declining social mobility in the
United States. Recent (2006-7) studies by the OECD
(Organization for Economic Cooperation and
Development) clearly demonstrate that the American
Dream is a myth. In an editorial dated July 13, 2007, the
New-York Times described the rapidly deteriorating
situation thus:
"... (M)obility between generations — people doing
better or worse than their parents — is weaker in
America than in Denmark, Austria, Norway, Finland,
Canada, Sweden, Germany, Spain and France. In
America, there is more than a 40 percent chance that if
a father is in the bottom fifth of the earnings’
distribution, his son will end up there, too. In Denmark,
the equivalent odds are under 25 percent, and they are
less than 30 percent in Britain.

America’s sluggish mobility is ultimately unsurprising.
Wealthy parents not only pass on that wealth in
inheritances, they can pay for better education, nutrition
and health care for their children. The poor cannot
afford this investment in their children’s development —
and the government doesn’t provide nearly enough help.
In a speech earlier this year, the Federal Reserve
chairman, Ben Bernanke, argued that while the
inequality of rewards fuels the economy by making
people exert themselves, opportunity should be “as
widely distributed and as equal as possible.” The
problem is that the have-nots don’t have many
opportunities either."
Still, entrepreneurs recombine natural and human
resources in novel ways. They do so to respond to
forecasts of future needs, or to observations of failures
and shortcomings of current products or services.
Entrepreneurs are professional - though usually intuitive futurologists. This is a valuable service and it is financed
by systematic risk takers, such as venture capitalists.
Surely they all deserve compensation for their efforts and
the hazards they assume?
Exclusive ownership is the most ancient type of such
remuneration. First movers, entrepreneurs, risk takers,
owners of the wealth they generated, exploiters of
resources - are allowed to exclude others from owning or
exploiting the same things. Mineral concessions, patents,
copyright, trademarks - are all forms of monopoly
ownership. What moral right to exclude others is gained
from being the first?
Nozick advanced Locke's Proviso. An exclusive
ownership of property is just only if "enough and as good
is left in common for others". If it does not worsen other

people's lot, exclusivity is morally permissible. It can be
argued, though, that all modes of exclusive ownership
aggravate other people's situation. As far as everyone, bar
the entrepreneur, are concerned, exclusivity also prevents
a more advantageous distribution of income and wealth.
Exclusive ownership reflects real-life irreversibility. A
first mover has the advantage of excess information and of
irreversibly invested work, time, and effort. Economic
enterprise is subject to information asymmetry: we know
nothing about the future and everything about the past.
This asymmetry is known as "investment risk". Society
compensates the entrepreneur with one type of asymmetry
- exclusive ownership - for assuming another, the
investment risk.
One way of looking at it is that all others are worse off by
the amount of profits and rents accruing to ownerentrepreneurs. Profits and rents reflect an intrinsic
inefficiency. Another is to recall that ownership is the
result of adding value to the world. It is only reasonable to
expect it to yield to the entrepreneur at least this value
added now and in the future.
In a "Theory of Justice" (published 1971, p. 302), John
Rawls described an ideal society thus:
"(1) Each person is to have an equal right to the most
extensive total system of equal basic liberties compatible
with a similar system of liberty for all. (2) Social and
economic inequalities are to be arranged so that they are
both: (a) to the greatest benefit of the least advantaged,
consistent with the just savings principle, and (b) attached
to offices and positions open to all under conditions of fair
equality of opportunity."

It all harks back to scarcity of resources - land, money,
raw materials, manpower, creative brains. Those who can
afford to do so, hoard resources to offset anxiety regarding
future uncertainty. Others wallow in paucity. The
distribution of means is thus skewed. "Distributive
justice" deals with the just allocation of scarce resources.
Yet, even the basic terminology is somewhat fuzzy. What
constitutes a resource? what is meant by allocation? Who
should allocate resources - Adam Smith's "invisible hand",
the government, the consumer, or business? Should it
reflect differences in power, in intelligence, in knowledge,
or in heredity? Should resource allocation be subject to a
principle of entitlement? Is it reasonable to demand that it
be just - or merely efficient? Are justice and efficiency
antonyms?
Justice is concerned with equal access to opportunities.
Equal access does not guarantee equal outcomes,
invariably determined by idiosyncrasies and differences
between people. Access leveraged by the application of
natural or acquired capacities - translates into accrued
wealth. Disparities in these capacities lead to
discrepancies in accrued wealth.
The doctrine of equal access is founded on the
equivalence of Men. That all men are created equal and
deserve the same respect and, therefore, equal treatment is
not self evident. European aristocracy well into this
century would have probably found this notion abhorrent.
Jose Ortega Y Gasset, writing in the 1930's, preached that
access to educational and economic opportunities should
be premised on one's lineage, up bringing, wealth, and
social responsibilities.
A succession of societies and cultures discriminated

against the ignorant, criminals, atheists, females,
homosexuals, members of ethnic, religious, or racial
groups, the old, the immigrant, and the poor. Communism
- ostensibly a strict egalitarian idea - foundered because it
failed to reconcile strict equality with economic and
psychological realities within an impatient timetable.
Philosophers tried to specify a "bundle" or "package" of
goods, services, and intangibles (like information, or
skills, or knowledge). Justice - though not necessarily
happiness - is when everyone possesses an identical
bundle. Happiness - though not necessarily justice - is
when each one of us possesses a "bundle" which reflects
his or her preferences, priorities, and predilections. None
of us will be too happy with a standardized bundle,
selected by a committee of philosophers - or bureaucrats,
as was the case under communism.
The market allows for the exchange of goods and services
between holders of identical bundles. If I seek books, but
detest oranges - I can swap them with someone in return
for his books. That way both of us are rendered better off
than under the strict egalitarian version.
Still, there is no guarantee that I will find my exact match
- a person who is interested in swapping his books for my
oranges. Illiquid, small, or imperfect markets thus inhibit
the scope of these exchanges. Additionally, exchange
participants have to agree on an index: how many books
for how many oranges? This is the price of oranges in
terms of books.
Money - the obvious "index" - does not solve this
problem, merely simplifies it and facilitates exchanges. It
does not eliminate the necessity to negotiate an "exchange
rate". It does not prevent market failures. In other words:

money is not an index. It is merely a medium of exchange
and a store of value. The index - as expressed in terms of
money - is the underlying agreement regarding the values
of resources in terms of other resources (i.e., their relative
values).
The market - and the price mechanism - increase
happiness and welfare by allowing people to alter the
composition of their bundles. The invisible hand is just
and benevolent. But money is imperfect. The
aforementioned Rawles demonstrated (1971), that we
need to combine money with other measures in order to
place a value on intangibles.
The prevailing market theories postulate that everyone has
the same resources at some initial point (the "starting
gate"). It is up to them to deploy these endowments and,
thus, to ravage or increase their wealth. While the initial
distribution is equal - the end distribution depends on how
wisely - or imprudently - the initial distribution was used.
Egalitarian thinkers proposed to equate everyone's income
in each time frame (e.g., annually). But identical incomes
do not automatically yield the same accrued wealth. The
latter depends on how the income is used - saved,
invested, or squandered. Relative disparities of wealth are
bound to emerge, regardless of the nature of income
distribution.
Some say that excess wealth should be confiscated and
redistributed. Progressive taxation and the welfare state
aim to secure this outcome. Redistributive mechanisms
reset the "wealth clock" periodically (at the end of every
month, or fiscal year). In many countries, the law dictates
which portion of one's income must be saved and, by
implication, how much can be consumed. This conflicts

with basic rights like the freedom to make economic
choices.
The legalized expropriation of income (i.e., taxes) is
morally dubious. Anti-tax movements have sprung all
over the world and their philosophy permeates the
ideology of political parties in many countries, not least
the USA. Taxes are punitive: they penalize enterprise,
success, entrepreneurship, foresight, and risk assumption.
Welfare, on the other hand, rewards dependence and
parasitism.
According to Rawles' Difference Principle, all tenets of
justice are either redistributive or retributive. This ignores
non-economic activities and human inherent variance.
Moreover, conflict and inequality are the engines of
growth and innovation - which mostly benefit the least
advantaged in the long run. Experience shows that
unmitigated equality results in atrophy, corruption and
stagnation. Thermodynamics teaches us that life and
motion are engendered by an irregular distribution of
energy. Entropy - an even distribution of energy - equals
death and stasis.
What about the disadvantaged and challenged - the
mentally retarded, the mentally insane, the paralyzed, the
chronically ill? For that matter, what about the less
talented, less skilled, less daring? Dworkin (1981)
proposed a compensation scheme. He suggested a model
of fair distribution in which every person is given the
same purchasing power and uses it to bid, in a fair
auction, for resources that best fit that person's life plan,
goals and preferences.
Having thus acquired these resources, we are then
permitted to use them as we see fit. Obviously, we end up

with disparate economic results. But we cannot complain we were given the same purchasing power and the
freedom to bid for a bundle of our choice.
Dworkin assumes that prior to the hypothetical auction,
people are unaware of their own natural endowments but
are willing and able to insure against being naturally
disadvantaged. Their payments create an insurance pool to
compensate the less fortunate for their misfortune.
This, of course, is highly unrealistic. We are usually very
much aware of natural endowments and liabilities - both
ours and others'. Therefore, the demand for such insurance
is not universal, nor uniform. Some of us badly need and
want it - others not at all. It is morally acceptable to let
willing buyers and sellers to trade in such coverage (e.g.,
by offering charity or alms) - but may be immoral to make
it compulsory.
Most of the modern welfare programs are involuntary
Dworkin schemes. Worse yet, they often measure
differences in natural endowments arbitrarily, compensate
for lack of acquired skills, and discriminate between types
of endowments in accordance with cultural biases and
fads.
Libertarians limit themselves to ensuring a level playing
field of just exchanges, where just actions always result in
just outcomes. Justice is not dependent on a particular
distribution pattern, whether as a starting point, or as an
outcome. Robert Nozick "Entitlement Theory" proposed
in 1974 is based on this approach.
That the market is wiser than any of its participants is a
pillar of the philosophy of capitalism. In its pure form, the
theory claims that markets yield patterns of merited

distribution - i.e., reward and punish justly. Capitalism
generate just deserts. Market failures - for instance, in the
provision of public goods - should be tackled by
governments. But a just distribution of income and wealth
does not constitute a market failure and, therefore, should
not be tampered with.
Also Read:
The Principal-Agent Conundrum
The Green-Eyed Capitalist
The Misconception of Scarcity
Return

Notes on the Economics of Game Theory
Consider this:
Could Western management techniques be successfully
implemented in the countries of Central and Eastern
Europe (CEE)? Granted, they have to be adapted,
modified and cannot be imported in their entirety. But
their crux, their inalienable nucleus â&#x20AC;&#x201C; can this be
transported and transplanted in CEE? Theory provides us
with a positive answer. Human agents are the same
everywhere and are mostly rational. Practice begs to
differ. Basic concepts such as the money value of time or
the moral and legal meaning of property are non existent.
The legal, political and economic environments are all
unpredictable. As a result, economic players will prefer to
maximize their utility immediately (steal from the
workplace, for instance) â&#x20AC;&#x201C; than to wait for longer term
(potentially, larger) benefits. Warrants (stock options)
convertible to the company's shares constitute a strong
workplace incentive in the West (because there is an
horizon and they increase the employee's welfare in the
long term). Where the future is speculation â&#x20AC;&#x201C; speculation
withers. Stock options or a small stake in his firm, will
only encourage the employee to blackmail the other
shareholders by paralysing the firm, to abuse his new
position and will be interpreted as immunity, conferred
from above, from the consequences of illegal activities.
The very allocation of options or shares will be interpreted
as a sign of weakness, dependence and need, to be
exploited. Hierarchy is equated with slavery and
employees will rather harm their long term interests than

follow instructions or be subjected to criticism â&#x20AC;&#x201C; never
mind how constructive. The employees in CEE regard the
corporate environment as a conflict zone, a zero sum
game (in which the gains by some equal the losses to
others). In the West, the employees participate in the
increase in the firm's value. The difference between these
attitudes is irreconcilable.
Now, let us consider this:
An entrepreneur is a person who is gifted at identifying
the unsatisfied needs of a market, at mobilizing and
organizing the resources required to satisfy those needs
and at defining a long-term strategy of development and
marketing. As the enterprise grows, two processes
combine to denude the entrepreneur of some of his initial
functions. The firm has ever growing needs for capital:
financial, human, assets and so on. Additionally, the
company begins (or should begin) to interface and interact
with older, better established firms. Thus, the company is
forced to create its first management team: a general
manager with the right doses of respectability,
connections and skills, a chief financial officer, a host of
consultants and so on. In theory â&#x20AC;&#x201C; if all our properly
motivated financially â&#x20AC;&#x201C; all these players (entrepreneurs
and managers) will seek to maximize the value of the
firm. What happens, in reality, is that both work to
minimize it, each for its own reasons. The managers seek
to maximize their short-term utility by securing enormous
pay packages and other forms of company-dilapidating
compensation. The entrepreneurs feel that they are
"strangled", "shackled", "held back" by bureaucracy and
they "rebel". They oust the management, or undermine it,
turning it into an ineffective representative relic. They
assume real, though informal, control of the firm. They do

so by defining a new set of strategic goals for the firm,
which call for the institution of an entrepreneurial rather
than a bureaucratic type of management. These cycles of
initiative-consolidation-new initiative-revolutionconsolidation are the dynamos of company growth.
Growth leads to maximization of value. However, the
players don't know or do not fully believe that they are in
the process of maximizing the company's worth. On the
contrary, consciously, the managers say: "Let's maximize
the benefits that we derive from this company, as long as
we are still here." The entrepreneurs-owners say: "We
cannot tolerate this stifling bureaucracy any longer. We
prefer to have a smaller company â&#x20AC;&#x201C; but all ours." The
growth cycles forces the entrepreneurs to dilute their
holdings (in order to raise the capital necessary to finance
their initiatives). This dilution (the fracturing of the
ownership structure) is what brings the last cycle to its
end. The holdings of the entrepreneurs are too small to
materialize a coup against the management. The
management then prevails and the entrepreneurs are
neutralized and move on to establish another start-up. The
only thing that they leave behind them is their names and
their heirs.
We can use Game Theory methods to analyse both these
situations. Wherever we have economic players
bargaining for the allocation of scarce resources in order
to attain their utility functions, to secure the outcomes and
consequences (the value, the preference, that the player
attaches to his outcomes) which are right for them â&#x20AC;&#x201C; we
can use Game Theory (GT).
A short recap of the basic tenets of the theory might be in
order.
GT deals with interactions between agents, whether

conscious and intelligent â&#x20AC;&#x201C; or Dennettic. A Dennettic
Agent (DA) is an agent that acts so as to influence the
future allocation of resources, but does not need to be
either conscious or deliberative to do so. A Game is the set
of acts committed by 1 to n rational DA and one a-rational
(not irrational but devoid of rationality) DA (nature, a
random mechanism). At least 1 DA in a Game must
control the result of the set of acts and the DAs must be
(at least potentially) at conflict, whole or partial. This is
not to say that all the DAs aspire to the same things. They
have different priorities and preferences. They rank the
likely outcomes of their acts differently. They engage
Strategies to obtain their highest ranked outcome. A
Strategy is a vector, which details the acts, with which the
DA will react in response to all the (possible) acts by the
other DAs. An agent is said to be rational if his Strategy
does guarantee the attainment of his most preferred goal.
Nature is involved by assigning probabilities to the
outcomes. An outcome, therefore, is an allocation of
resources resulting from the acts of the agents. An agent is
said to control the situation if its acts matter to others to
the extent that at least one of them is forced to alter at
least one vector (Strategy). The Consequence to the agent
is the value of a function that assigns real numbers to each
of the outcomes. The consequence represents a list of
outcomes, prioritized, ranked. It is also known as an
ordinal utility function. If the function includes relative
numerical importance measures (not only real numbers) â&#x20AC;&#x201C;
we call it a Cardinal Utility Function.
Games, naturally, can consist of one player, two players
and more than two players (n-players). They can be zero
(or fixed) - sum (the sum of benefits is fixed and whatever
gains made by one of the players are lost by the others).
They can be nonzero-sum (the amount of benefits to all

players can increase or decrease). Games can be
cooperative (where some of the players or all of them
form coalitions) – or non-cooperative (competitive). For
some of the games, the solutions are called Nash
equilibria. They are sets of strategies constructed so that
an agent which adopts them (and, as a result, secures a
certain outcome) will have no incentive to switch over to
other strategies (given the strategies of all other players).
Nash equilibria (solutions) are the most stable (it is where
the system "settles down", to borrow from Chaos Theory)
– but they are not guaranteed to be the most desirable.
Consider the famous "Prisoners' Dilemma" in which both
players play rationally and reach the Nash equilibrium
only to discover that they could have done much better by
collaborating (that is, by playing irrationally). Instead,
they adopt the "Paretto-dominated", or the "Parettooptimal", sub-optimal solution. Any outside interference
with the game (for instance, legislation) will be construed
as creating a NEW game, not as pushing the players to
adopt a "Paretto-superior" solution.
The behaviour of the players reveals to us their order of
preferences. This is called "Preference Ordering" or
"Revealed Preference Theory". Agents are faced with sets
of possible states of the world (=allocations of resources,
to be more economically inclined). These are called
"Bundles". In certain cases they can trade their bundles,
swap them with others. The evidence of these swaps will
inevitably reveal to us the order of priorities of the agent.
All the bundles that enjoy the same ranking by a given
agent – are this agent's "Indifference Sets". The
construction of an Ordinal Utility Function is, thus, made
simple. The indifference sets are numbered from 1 to n.
These ordinals do not reveal the INTENSITY or the
RELATIVE INTENSITY of a preference – merely its

location in a list. However, techniques are available to
transform the ordinal utility function – into a cardinal one.
A Stable Strategy is similar to a Nash solution – though
not identical mathematically. There is currently no
comprehensive theory of Information Dynamics. Game
Theory is limited to the aspects of competition and
exchange of information (cooperation). Strategies that
lead to better results (independently of other agents) are
dominant and where all the agents have dominant
strategies – a solution is established. Thus, the Nash
equilibrium is applicable to games that are repeated and
wherein each agent reacts to the acts of other agents. The
agent is influenced by others – but does not influence
them (he is negligible). The agent continues to adapt in
this way – until no longer able to improve his position.
The Nash solution is less available in cases of cooperation
and is not unique as a solution. In most cases, the players
will adopt a minimax strategy (in zero-sum games) or
maximin strategies (in nonzero-sum games). These
strategies guarantee that the loser will not lose more than
the value of the game and that the winner will gain at least
this value. The solution is the "Saddle Point".
The distinction between zero-sum games (ZSG) and
nonzero-sum games (NZSG) is not trivial. A player
playing a ZSG cannot gain if prohibited to use certain
strategies. This is not the case in NZSGs. In ZSG, the
player does not benefit from exposing his strategy to his
rival and is never harmed by having foreknowledge of his
rival's strategy. Not so in NZSGs: at times, a player stands
to gain by revealing his plans to the "enemy". A player
can actually be harmed by NOT declaring his strategy or
by gaining acquaintance with the enemy's stratagems. The
very ability to communicate, the level of communication

and the order of communication â&#x20AC;&#x201C; are important in
cooperative cases. A Nash solution:
1. Is not dependent upon any utility function;
2. It is impossible for two players to improve the
Nash solution (=their position) simultaneously
(=the Paretto optimality);
3. Is not influenced by the introduction of irrelevant
(not very gainful) alternatives; and
4. Is symmetric (reversing the roles of the players
does not affect the solution).
The limitations of this approach are immediately evident.
It is definitely not geared to cope well with more complex,
multi-player, semi-cooperative (semi-competitive),
imperfect information situations.
Von Neumann proved that there is a solution for every
ZSG with 2 players, though it might require the
implementation of mixed strategies (strategies with
probabilities attached to every move and outcome).
Together with the economist Morgenstern, he developed
an approach to coalitions (cooperative efforts of one or
more players â&#x20AC;&#x201C; a coalition of one player is possible).
Every coalition has a value â&#x20AC;&#x201C; a minimal amount that the
coalition can secure using solely its own efforts and
resources. The function describing this value is superadditive (the value of a coalition which is comprised of
two sub-coalitions equals, at least, the sum of the values
of the two sub-coalitions). Coalitions can be
epiphenomenal: their value can be higher than the
combined values of their constituents. The amounts paid
to the players equal the value of the coalition and each
player stands to get an amount no smaller than any

amount that he would have made on his own. A set of
payments to the players, describing the division of the
coalition's value amongst them, is the "imputation", a
single outcome of a strategy. A strategy is, therefore,
dominant, if: (1) each player is getting more under the
strategy than under any other strategy and (2) the players
in the coalition receive a total payment that does not
exceed the value of the coalition. Rational players are
likely to prefer the dominant strategy and to enforce it.
Thus, the solution to an n-players game is a set of
imputations. No single imputation in the solution must be
dominant (=better). They should all lead to equally
desirable results. On the other hand, all the imputations
outside the solution should be dominated. Some games are
without solution (Lucas, 1967).
Auman and Maschler tried to establish what is the right
payoff to the members of a coalition. They went about it
by enlarging upon the concept of bargaining (threats,
bluffs, offers and counter-offers). Every imputation was
examined, separately, whether it belongs in the solution
(=yields the highest ranked outcome) or not, regardless of
the other imputations in the solution. But in their theory,
every member had the right to "object" to the inclusion of
other members in the coalition by suggesting a different,
exclusionary, coalition in which the members stand to
gain a larger payoff. The player about to be excluded can
"counter-argue" by demonstrating the existence of yet
another coalition in which the members will get at least as
much as in the first coalition and in the coalition proposed
by his adversary, the "objector". Each coalition has, at
least, one solution.
The Game in GT is an idealized concept. Some of the
assumptions can â&#x20AC;&#x201C; and should be argued against. The

number of agents in any game is assumed to be finite and
a finite number of steps is mostly incorporated into the
assumptions. Omissions are not treated as acts (though
negative ones). All agents are negligible in their
relationship to others (have no discernible influence on
them) – yet are influenced by them (their strategies are not
– but the specific moves that they select – are). The
comparison of utilities is not the result of any ranking –
because no universal ranking is possible. Actually, no
ranking common to two or n players is possible (rankings
are bound to differ among players). Many of the problems
are linked to the variant of rationality used in GT. It is
comprised of a clarity of preferences on behalf of the
rational agent and relies on the people's tendency to
converge and cluster around the right answer / move.
This, however, is only a tendency. Some of the time,
players select the wrong moves. It would have been much
wiser to assume that there are no pure strategies, that all
of them are mixed. Game Theory would have done well to
borrow mathematical techniques from quantum
mechanics. For instance: strategies could have been
described as wave functions with probability distributions.
The same treatment could be accorded to the cardinal
utility function. Obviously, the highest ranking (smallest
ordinal) preference should have had the biggest
probability attached to it – or could be treated as the
collapse event. But these are more or less known, even
trivial, objections. Some of them cannot be overcome. We
must idealize the world in order to be able to relate to it
scientifically at all. The idealization process entails the
incorporation of gross inaccuracies into the model and the
ignorance of other elements. The surprise is that the
approximation yields results, which tally closely with
reality – in view of its mutilation, affected by the model.

There are more serious problems, philosophical in nature.
It is generally agreed that "changing" the game can – and
very often does – move the players from a noncooperative mode (leading to Paretto-dominated results,
which are never desirable) – to a cooperative one. A
government can force its citizens to cooperate and to obey
the law. It can enforce this cooperation. This is often
called a Hobbesian dilemma. It arises even in a population
made up entirely of altruists. Different utility functions
and the process of bargaining are likely to drive these
good souls to threaten to become egoists unless other
altruists adopt their utility function (their preferences,
their bundles). Nash proved that there is an allocation of
possible utility functions to these agents so that the
equilibrium strategy for each one of them will be this kind
of threat. This is a clear social Hobbesian dilemma: the
equilibrium is absolute egoism despite the fact that all the
players are altruists. This implies that we can learn very
little about the outcomes of competitive situations from
acquainting ourselves with the psychological facts
pertaining to the players. The agents, in this example, are
not selfish or irrational – and, still, they deteriorate in their
behaviour, to utter egotism. A complete set of utility
functions – including details regarding how much they
know about one another's utility functions – defines the
available equilibrium strategies. The altruists in our
example are prisoners of the logic of the game. Only an
"outside" power can release them from their predicament
and permit them to materialize their true nature. Gauthier
said that morally-constrained agents are more likely to
evade Paretto-dominated outcomes in competitive games
– than agents who are constrained only rationally. But this
is unconvincing without the existence of an Hobesian
enforcement mechanism (a state is the most common

one). Players would do better to avoid Paretto dominated
outcomes by imposing the constraints of such a
mechanism upon their available strategies. Paretto
optimality is defined as efficiency, when there is no state
of things (a different distribution of resources) in which at
least one player is better off – with all the other no worse
off. "Better off" read: "with his preference satisfied". This
definitely could lead to cooperation (to avoid a bad
outcome) – but it cannot be shown to lead to the formation
of morality, however basic. Criminals can achieve their
goals in splendid cooperation and be content, but that does
not make it more moral. Game theory is agent neutral, it is
utilitarianism at its apex. It does not prescribe to the agent
what is "good" – only what is "right". It is the ultimate
proof that effort at reconciling utilitarianism with more
deontological, agent relative, approaches are dubious, in
the best of cases. Teleology, in other words, in no
guarantee of morality.
Acts are either means to an end or ends in themselves.
This is no infinite regression. There is bound to be an holy
grail (happiness?) in the role of the ultimate end. A more
commonsense view would be to regard acts as means and
states of affairs as ends. This, in turn, leads to a
teleological outlook: acts are right or wrong in accordance
with their effectiveness at securing the achievement of the
right goals. Deontology (and its stronger version,
absolutism) constrain the means. It states that there is a
permitted subset of means, all the other being immoral
and, in effect, forbidden. Game Theory is out to shatter
both the notion of a finite chain of means and ends
culminating in an ultimate end – and of the deontological
view. It is consequentialist but devoid of any value
judgement.

Game Theory pretends that human actions are breakable
into much smaller "molecules" called games. Human acts
within these games are means to achieving ends but the
ends are improbable in their finality. The means are
segments of "strategies": prescient and omniscient
renditions of the possible moves of all the players. Aside
from the fact that it involves mnemic causation (direct and
deterministic influence by past events) and a similar
influence by the utility function (which really pertains to
the future) â&#x20AC;&#x201C; it is highly implausible. Additionally, Game
Theory is mired in an internal contradiction: on the one
hand it solemnly teaches us that the psychology of the
players is absolutely of no consequence. On the other, it
hastens to explicitly and axiomatically postulate their
rationality and implicitly (and no less axiomatically) their
benefit-seeking behaviour (though this aspect is much
more muted). This leads to absolutely outlandish results:
irrational behaviour leads to total cooperation, bounded
rationality leads to more realistic patterns of cooperation
and competition (coopetition) and an unmitigated rational
behaviour leads to disaster (also known as Paretto
dominated outcomes).
Moreover, Game Theory refuses to acknowledge that real
games are dynamic, not static. The very concepts of
strategy, utility function and extensive (tree like)
representation are static. The dynamic is retrospective, not
prospective. To be dynamic, the game must include all the
information about all the actors, all their strategies, all
their utility functions. Each game is a subset of a higher
level game, a private case of an implicit game which is
constantly played in the background, so to say. This is a
hyper-game of which all games are but derivatives. It
incorporates all the physically possible moves of all the
players. An outside agency with enforcement powers (the

state, the police, the courts, the law) are introduced by the
players. In this sense, they are not really an outside event
which has the effect of altering the game fundamentally.
They are part and parcel of the strategies available to the
players and cannot be arbitrarily ruled out. On the
contrary, their introduction as part of a dominant strategy
will simplify Game theory and make it much more
applicable. In other words: players can choose to compete,
to cooperate and to cooperate in the formation of an
outside agency. There is no logical or mathematical reason
to exclude the latter possibility. The ability to thus
influence the game is a legitimate part of any real life
strategy. Game Theory assumes that the game is a given â&#x20AC;&#x201C;
and the players have to optimize their results within it. It
should open itself to the inclusion of game altering or
redefining moves by the players as an integral part of their
strategies. After all, games entail the existence of some
agreement to play and this means that the players accept
some rules (this is the role of the prosecutor in the
Prisoners' Dilemma). If some outside rules (of the game)
are permissible â&#x20AC;&#x201C; why not allow the "risk" that all the
players will agree to form an outside, lawfully binding,
arbitration and enforcement agency â&#x20AC;&#x201C; as part of the game?
Such an agency will be nothing if not the embodiment, the
materialization of one of the rules, a move in the players'
strategies, leading them to more optimal or superior
outcomes as far as their utility functions are concerned.
Bargaining inevitably leads to an agreement regarding a
decision making procedure. An outside agency, which
enforces cooperation and some moral code, is such a
decision making procedure. It is not an "outside" agency
in the true, physical, sense. It does not "alter" the game
(not to mention its rules). It IS the game, it is a procedure,
a way to resolve conflicts, an integral part of any solution
and imputation, the herald of cooperation, a representative

of some of the will of all the players and, therefore, a part
both of their utility functions and of their strategies to
obtain their preferred outcomes. Really, these outside
agencies ARE the desired outcomes. Once Game Theory
digests this observation, it could tackle reality rather than
its own idealized contraptions.
Also Read
The Madness of Playing Games
Games People Play

Return

The Spectrum of Auctions
Months of procrastination and righteous protestations to
the contrary led to the inevitable: the European
Commission assented last week to a joint venture between
Germany's T-mobile and Britain's mmO2 to share the
mammoth costs of erecting third generation - 3G in the
parlance - mobile phone networks in both countries. The
two companies were among the accursed winners of a
series of spectrum auctions in the late 1990's. Altogether
telecom firms shelled well over $100 billion to secure 3G
licences in markets as diverse as Germany, Italy, the UK,
and the Netherlands.
There is little doubt that governments - and, through them,
the public - have made a killing in these auctions. But
paying the fees left the winners' coffers depleted. They are
now unable to comply with the licence terms and provide
the service that is supposed to revolutionize wireless
communications and data retrieval.
Judged narrowly, from the sellers' point of view, these
auctions have been an astounding success. But the
outcomes of the best auctions encompass the widest
possible utility - including the buyers' and the public's.
From this wider angle, go the critics, spectrum auctions
have been an abysmal failure.
This is surprising. Auctions are nothing new. The
notorious slave fairs of the 18th and 19th century were
auction markets. Similar bazaars existed in ancient
Greece. Many commodities, such as US loose leaf

tobacco, are exclusively sold in such tenders as are
government bonds, second hand goods, used machinery,
artworks, antiques, stamps, old coins, rare books, jewelry,
and property foreclosed by financial institutions or
expropriated by the government. Several stock and
commodity exchanges the world over are auction-based. A
branch of game theory - auction theory - deals with the
intricacies of auctions and how they can be frustrated by
collusion implicit or explicit.
All auctions are managed by an auctioneer who rewards
the desired article to the highest bidder and charges the
seller - and sometimes the bidder a fee, a percentage of
the realized price. In almost all auctions, the seller sets a published or undisclosed - "reserve" price - the lowest bid
it is willing to accept and below which the item is
"reserved", i.e., goes unsold.
In an English "open outcry" auction, bids are made public,
allowing other bidders to up the ante. In a first-price - or
discriminatory - sealed bid auction, bids remain secret
until the auctioneer opens the sealed envelopes at a predetermined time. In the Vickrey - or uniform second price
- auction the winner pays an amount equal to the second
highest bid. In a Dutch auction, the auctioneer announces
a series of decreasing prices and awards the article to the
first bidder. These epithets are used in financial markets to
designate other types of auctions.
Auctions are no longer considered the most efficient
method in markets with imperfect competition - as most
markets are.
Steve Kaplan and Mohanbir Sawhney noted in an article
published by the Harvard Business Review two years ago
that the advent of the Internet removed two handicaps. It

allows an unlimited number of potential bidders and
sellers to congregate virtually on Web sites such as eBay.
It also eliminated the substantial costs of traditional,
physical, auctions. The process of matching buyers with
sellers - i.e., finding equilibrium prices which clear supply
and demand efficiently - was also simplified in e-hubs.
Yet, as Paul Milgrom of Stanford University pointed out
to "The Economist":
"Arguments that online exchanges will produce big
increases in efficiency ... implicitly assume that the
Internet will make markets perfectly competitive - with
homogeneous products and competition on price alone ...
(ignore the fact that) markets for most goods and services
in fact have 'imperfect competition' - similar but slightly
differentiated products competing on many things besides
price."
Moreover, as Paul Klemperer of Oxford University
observes, bidders sometimes collude - explicitly, in
"rings", or implicitly, by signaling each other - to rig the
process or deter "outsider" entrants. New participants
often underbid, expecting incumbents to overbid.
An FCC auction of wireless data transmission frequencies
in April 1997 raised only $14 million - rather than the
$1.8 billion expected. This was apparently achieved by
signals to warn off competitors embedded in the bids
themselves. Salomon Brothers admitted, in August 1991,
to manipulating US treasury auctions - by submitting fake
bids - and paid a fine of $290 million.
Another problem is the "winner's curse" - the tendency to
bid too high to ensure winning. Wary of this propensity,
bidders often bid too low - especially in sealed bid

auctions or in auctions with many bidders, says Jeremy
Bulow of Stanford University in a paper he co-authored
with Klemperer. And, as opposed to fixed prices,
preparing for an auction consumes resources while the
risk of losing is high.
So, are the critics right? Have the 3G auctions - due to
their inherent imperfections or erroneous design - brought
the winners to their pecuniary knees? will the sunk costs
of the licence fees be passed on to reluctant consumers?
Should the European Commission and governments in
Europe allow winners to co-invest, co-own, co-operate,
and co-maintain their networks?
This, at best, is debatable.
Frequencies are a commodity in perfect competition though their price (their "common value") is unknown.
Theoretically, auctioning the spectrum is the most
efficient way to make bidders pay for their "monopoly
rent" - i.e., their excess profits. Bidders know best where
their interests lie and how much they can pay and the
auction process extracts this information from them in the
form of a bid. They may misread the market and go bust but this is a risk every business takes.
Economic theory decouples the size of the bids from the
marginal return on investment. But, in the real world, the
higher the "commitment fees" in the shape of costs sunk
into obtaining the licenes - the more motivated the
winners are to recoup them by investing in infrastructure,
providing innovative services competitively, and
aggressively marketing their offerings. The licences are
fully tradable assets whose value depends on added
investment in networks and customers.

Too late, telcoms are realizing the magnitude of their
mistake. Consumers are ill-prepared for the wireless
Internet. Clashing standards, incompatible devices,
reluctant hardware manufacturers, the spread of
broadband, the recession - all conspire to undermine the
sanguine business plans of yesteryear. Yet, getting it
wrong does not justify a bail-out. On the very contrary,
the losers should be purged by that famous invisible hand.
Inexorable and merciless as it may be, the market unencumbered by state intervention - always ends up
delivering commercial, non-public, goods cheaply and
efficiently.
Return

Distributions to Partners and Shareholders
It is when the going gets better, that the going gets tough.
This enigmatic sentence bears explanation: when a firm is
in dire straits, in the throes of a crisis, or is a loss maker â&#x20AC;&#x201C;
conflicts between the shareholders (partners) are rare.
When a company is in the start-up phase, conducting
research and development and fighting for its continued,
profitable survival in the midst of a massive investment
cycle â&#x20AC;&#x201C; rarely will internal strife arise and threaten its
existence. It is when the company turns a profit, when
there is cash in the till â&#x20AC;&#x201C; that, typically, all manner of
grievances, complaints and demands arise. The
internecine conflicts are especially acute where the
ownership is divided equally. It is more accentuated when
one of the partners feels that he is contributing more to the
business, either because of his unique talents or because
of his professional experience, contacts or due to the size
of his initial investments (and the other partner does not
share his views).
The typical grievances relate to the equitable,
proportional, division of the company's income between
the partners. In many firms partners serve in various
management functions and draw a salary plus expenses.
This is considered by other partners to be a dividend
drawn in disguise. They want to draw the same amounts
from the company's coffers (or to maintain some kind of
symbolic monetary difference in favour of the position
holder). Most minority partners are afraid of a tyranny of
the majority and of the company being robbed blind
(legally and less legally) by the partners in management

positions. Others are plainly jealous, poisoned by rumours
and bad advisors, pressurized by a spouse. A myriad of
reasons can lead to internal strife, detrimental to the future
of the operation.
This leads to a paralysis of the work of the company.
Management and ownership resources are dedicated to
taking sides in the raging battle and to thinking up new
strategies and tactics of attacking "the enemy". Indeed,
animosity, even enmity, arise together with bitterness and
air of paranoia and impending implosion. The business
itself is neglected, then derailed. Directors argue for hours
regarding their perks and benefits â&#x20AC;&#x201C; and deal with the
main issues in a matter of a few minutes. The company
car gets more attention than the company's main clients,
the expense accounts are more closely scrutinized than the
marketing strategies of the firm's competitors. This is
disastrous and before long the company begins to lose
clients, its marketing position degenerates, its
performance and customer satisfaction deteriorate. This is
mortal danger and it should be nipped in the bud.
Frankly, I do not believe much in introducing rational
solutions to this highly charged EMOTIVEPSYCHOLOGICAL problem. Logic cannot eliminate
envy, ratio cannot cope with jealousy and bad mouthing
will not stop if certain visible disparities are addressed.
Still, dealing with the situation openly is better than
relegating it to obscurity.
We must, first, make a distinction between a division of
the company's assets and liabilities upon a dissolution of
the partnership for whatever reason â&#x20AC;&#x201C; and the distribution
of its on-going revenues or profits.
In the first case (dissolution), the best solution I know of,

is practised by the Bedouins in the Sinai Peninsula. For
simplification's sake, let us discuss a collaboration
between two equal partners that is coming to its end. One
of the partners is then charged with dividing the
partnership's assets and liabilities into two lots (that he
deems equal). The other partner is then given the right of
being the FIRST to choose one of the lots to himself. This
is an ingenious scheme: the partner in charge of allocating
the lots will do his utmost to ensure that they are indeed
identical. Each lot will, probably, contain values of assets
and liabilities identical to the other lot. This is because the
partner in charge of the division does not know WHICH
lot the other partner will choose. If he divides the lots
unevenly – he runs the risk of his partner choosing the
better lot and leaving him with the lesser one.
Life is not that simple when it comes to dividing a stream
of income or of profits. Income can be distributed to the
shareholders in many ways: wages, perks and benefits,
expense accounts, and dividends. It is difficult to
disentangle what money is paid to a shareholder against a
real contribution – and what money is a camouflaged
dividend. Moreover, shareholders are supposed to
contribute to their firm (this is why they own shares) – so
why should they be especially compensated when they do
so? The latter question is particularly acute when the
shareholder is not a full time employee of the firm – but
allocates only a portion of his time and resources to it.
Solutions do exist, however. One category of solutions
involves coming up with a clear definition of the functions
of a shareholder (a job description). This is a prerequisite.
Without such clarity, it would be close to impossible to
quantify the respective contributions of the shareholders.
Following this detailed analysis, a pecuniary assessment

of the contribution should be made. This is a tricky part.
How to value the importance to the company of this or
that shareholder?
One way is to publish a public tender for the shareholder's
job, based on the aforementioned job description. The
shareholder will accept, in advance, to match the lowest
bid in the tender. Example: if the shareholder is the Active
Chairman of the Board, his job will be minutely described
in writing. Then, a tender will be published by the
company for the job, including a job description. A
committee, whose odd number of members will be
appointed by the Board of Directors, will select the
winner whose bid (cost) was the lowest. The shareholder
will match these low end terms. In other words: the
shareholder will accept the market's verdict. To perfect
this technique, the CURRENT functionaries should also
submit their bids under assumed names. This way, not
only the issue of their compensation will be determined â&#x20AC;&#x201C;
but also the more basic question of whether they are the
fittest for the job.
Another way is to consult executive search agencies and
personnel placement agencies (also known as
"Headhunters"). Such organizations can save the
prolonged hassle of a public tender, on the one hand. On
the other hand, their figures are likely to be skewed up.
Because they are getting a commission equal to one
monthly wage of the successfully placed executive â&#x20AC;&#x201C; they
will tend to quote a level of compensation higher than the
market's. An approach should, therefore, be made to at
least three such agencies and the resulting average figure
should be adjusted down by 10% (approximately the
commission payable to these agencies).
A closely similar method is to follow what other,

comparable, firms, are offering their position-holders.
This can be done by studying the classified ads and by
directly asking the companies (if such direct enquiry is at
all possible).
Yet another approach is to appoint a management
consultancy to do the job: are the shareholders the best
positioned people in their respective functions? Is their
compensation realistic? Should alternative management
methods be implemented (rotation, co-management,
management by committee)?
All the above mentioned are FORMAL techniques in
which arbitration is carried out to determine the
remuneration level befitting the shareholder's position.
Any compensation that he receives above this level is
evidently a hidden dividend. The arbitration can be carried
out directly by the market or by select specialists.
There are, however, more direct approaches. Some
solutions are performance related. A base compensation
(salary) is agreed between the parties: each shareholder,
regardless of his position, dedication to the job, or
contribution to the firm â&#x20AC;&#x201C; will take home an amount of
monthly fee reflecting his shareholding proportion or an
amount equal to the one received by other shareholders.
This, really, is the hidden dividend, disguised as a salary.
The remaining part of the compensation package will be
proportional to some performance criteria.
Let us take the simplest case: two equal partners. One is in
charge of activity A, which yields to the company AA in
income and AAA in profits (gross or net). The second
partner supervises and manages activity B, which yields to
the company BB in revenues and BBB in profits. Both
will receive an equal "base salary". Then, an additional

total amount available to both partners will be decided
("incentive base"). The first partner will receive an
additional amount, which will be one of the ratios
{AA/(AA+BB)} or {AAA/(AAA+BBB)} multiplied by
the incentive base.
The second partner will receive an additional amount,
which will be one of the ratios {BB/(AA+BB)} or
{BBB/(AAA+BBB)} multiplied by the same incentive
base. A recalculation of the compensation packages will
be done quarterly to reflect changes in revenues and in
profits. In case the activity yields losses â&#x20AC;&#x201C; it is better to
use the revenues for calculation purposes. The profits
should be used only when the firm is divided to clear
profit and loss centres, which could be completely
disentangled from each other.
All the above methods deal with partners whose
contributions are NOT equal (one is more experienced,
the other has more contacts, or a formal technological
education, etc.). These solutions are also applicable when
the partners DISAGREE concerning the valuation of their
respective contributions. When the partners agree that
they contribute equally, some basis can be agreed for
calculating a fair compensation. For instance: the number
of hours dedicated to the business, or even some arbitrary
coefficient.
But whatever the method employed, when there is no such
agreement between the partners, they should recognize
each other's skills, talents and specific contributions. The
compensation packages should never exceed what the
shareholders can reasonably expect to get by way of
dividends. Even the most envious person, if he knows that
his partner can bring him in dividends more than he can
ever hope for in compensation â&#x20AC;&#x201C; will succumb to greed

and award his partner what he needs in order to produce
those dividends.
Return

Moral Hazard and the Survival Value of Risk
Written May 2002
Updated June 2005
Risk transfer is the gist of modern economies. Citizens
pay taxes to ever expanding governments in return for a
variety of "safety nets" and state-sponsored insurance
schemes. Taxes can, therefore, be safely described as
insurance premiums paid by the citizenry. Firms extract
from consumers a markup above their costs to compensate
them for their business risks.
Profits can be easily cast as the premiums a firm charges
for the risks it assumes on behalf of its customers - i.e.,
risk transfer charges. Depositors charge banks and lenders
charge borrowers interest, partly to compensate for the
hazards of lending - such as the default risk. Shareholders
expect above "normal" - that is, risk-free - returns on their
investments in stocks. These are supposed to offset
trading liquidity, issuer insolvency, and market volatility
risks.
The reallocation and transfer of risk are booming
industries. Governments, capital markets, banks, and
insurance companies have all entered the fray with everevolving financial instruments. Pundits praise the virtues
of the commodification and trading of risk. It allows
entrepreneurs to assume more of it, banks to get rid of it,
and traders to hedge against it. Modern risk exchanges
liberated Western economies from the tyranny of the
uncertain - they enthuse.

But this is precisely the peril of these new developments.
They mass manufacture moral hazard. They remove the
only immutable incentive to succeed - market discipline
and business failure. They undermine the very fundaments
of capitalism: prices as signals, transmission channels,
risk and reward, opportunity cost. Risk reallocation, risk
transfer, and risk trading create an artificial universe in
which synthetic contracts replace real ones and third party
and moral hazards replace business risks.
Moral hazard is the risk that the behaviour of an economic
player will change as a result of the alleviation of real or
perceived potential costs. It has often been claimed that
IMF bailouts, in the wake of financial crises - in Mexico,
Brazil, Asia, and Turkey, to mention but a few - created
moral hazard.
Governments are willing to act imprudently, safe in the
knowledge that the IMF is a lender of last resort, which is
often steered by geopolitical considerations, rather than
merely economic ones. Creditors are more willing to lend
and at lower rates, reassured by the IMF's default-staving
safety net. Conversely, the IMF's refusal to assist Russia
in 1998 and Argentina in 2002 - should reduce moral
hazard.
The IMF, of course, denies this. In a paper titled "IMF
Financing and Moral Hazard", published June 2001, the
authors - Timothy Lane and Steven Phillips, two senior
IMF economists - state:
"... In order to make the case for abolishing or
drastically overhauling the IMF, one must show ... that
the moral hazard generated by the availability of IMF
financing overshadows any potentially beneficial effects
in mitigating crises ... Despite many assertions in policy

discussions that moral hazard is a major cause of
financial crises, there has been astonishingly little effort
to provide empirical support for this belief."
Yet, no one knows how to measure moral hazard. In an
efficient market, interest rate spreads on bonds reflect all
the information available to investors, not merely the
existence of moral hazard. Market reaction is often
delayed, partial, or distorted by subsequent developments.
Moreover, charges of "moral hazard" are frequently illinformed and haphazard. Even the venerable Wall Street
Journal fell in this fashionable trap. It labeled the Long
Term Capital Management (LTCM) 1998 salvage - "$3.5
billion worth of moral hazard". Yet, no public money was
used to rescue the sinking hedge fund and investors lost
most of their capital when the new lenders took over 90
percent of LTCM's equity.
In an inflationary turn of phrase, "moral hazard" is now
taken to encompass anti-cyclical measures, such as
interest rates cuts. The Fed - and its mythical Chairman,
Alan Greenspan - stand accused of bailing out the bloated
stock market by engaging in an uncontrolled spree of
interest rates reductions.
In a September 2001 paper titled "Moral Hazard and the
US Stock Market", the authors - Marcus Miller, Paul
Weller, and Lei Zhang, all respected academics - accuse
the Fed of creating a "Greenspan Put". In a scathing
commentary, they write:
"The risk premium in the US stock market has fallen
far below its historic level ... (It may have been) reduced
by one-sided intervention policy on the part of the
Federal Reserve which leads investors into the

erroneous belief that they are insured against downside
risk ... This insurance - referred to as the Greenspan Put
- (involves) exaggerated faith in the stabilizing power of
Mr. Greenspan."
Moral hazard infringes upon both transparency and
accountability. It is never explicit or known in advance. It
is always arbitrary, or subject to political and geopolitical
considerations. Thus, it serves to increase uncertainty
rather than decrease it. And by protecting private investors
and creditors from the outcomes of their errors and
misjudgments - it undermines the concept of liability.
The recurrent rescues of Mexico - following its systemic
crises in 1976, 1982, 1988, and 1994 - are textbook
examples of moral hazard. The Cato Institute called them,
in a 1995 Policy Analysis paper, "palliatives" which create
"perverse incentives" with regards to what it considers to
be misguided Mexican public policies - such as refusing
to float the peso.
Still, it can be convincingly argued that the problem of
moral hazard is most acute in the private sector.
Sovereigns can always inflate their way out of domestic
debt. Private foreign creditors implicitly assume
multilateral bailouts and endless rescheduling when
lending to TBTF or TITF ("too big or too important to
fail") countries. The debt of many sovereign borrowers,
therefore, is immune to terminal default.
Not so with private debtors. In remarks made by Gary
Stern, President of the Federal Reserve Bank of
Minneapolis, to the 35th Annual Conference on Bank
Structure and Competition, on May 1999, he said:
"I propose combining market signals of risk with the

best aspects of current regulation to help mitigate the
moral hazard problem that is most acute with our largest
banks ... The actual regulatory and legal changes
introduced over the period-although positive steps-are
inadequate to address the safety net's perversion of the
risk/return trade-off."
This observation is truer now than ever. Massconsolidation in the banking sector, mergers with nonbanking financial intermediaries (such as insurance
companies), and the introduction of credit derivatives and
other financial innovations - make the issue of moral
hazard all the more pressing.
Consider deposit insurance, provided by virtually every
government in the world. It allows the banks to pay to
depositors interest rates which do not reflect the banks'
inherent riskiness. As the costs of their liabilities decline
to unrealistic levels -banks misprice their assets as well.
They end up charging borrowers the wrong interest rates
or, more common, financing risky projects.
Badly managed banks pay higher premiums to secure
federal deposit insurance. But this disincentive is woefully
inadequate and disproportionate to the enormous benefits
reaped by virtue of having a safety net. Stern dismisses
this approach:
"The ability of regulators to contain moral hazard
directly is limited. Moral hazard results when economic
agents do not bear the marginal costs of their actions.
Regulatory reforms can alter marginal costs but they
accomplish this task through very crude and often
exploitable tactics. There should be limited confidence
that regulation and supervision will lead to bank
closures before institutions become insolvent. In

particular, reliance on lagging regulatory measures,
restrictive regulatory and legal norms, and the ability of
banks to quickly alter their risk profile have often
resulted in costly failures."
Stern concludes his remarks by repeating the age-old
advice: caveat emptor. Let depositors and creditors suffer
losses. This will enhance their propensity to discipline
market players. They are also likely to become more
selective and invest in assets which conform to their risk
aversion.
Both outcomes are highly dubious. Private sector creditors
and depositors have little leverage over delinquent debtors
or banks. When Russia - and trigger happy Russian firms defaulted on their obligations in 1998, even the largest
lenders, such as the EBRD, were unable to recover their
credits and investments.
The defrauded depositors of BCCI are still chasing the
assets of the defunct bank as well as litigating against the
Bank of England for allegedly having failed to supervise
it. Discipline imposed by depositors and creditors often
results in a "run on the bank" - or in bankruptcy. The
presumed ability of stakeholders to discipline risky
enterprises, hazardous financial institutions, and profligate
sovereigns is fallacious.
Asset selection within a well balanced and diversified
portfolio is also a bit of a daydream. Information - even in
the most regulated and liquid markets - is partial,
distorted, manipulative, and lagging. Insiders collude to
monopolize it and obtain a "first mover" advantage.
Intricate nets of patronage exclude the vast majority of
shareholders and co-opt ostensible checks and balances -

such as auditors, legislators, and regulators. Enough to
mention Enron and its accountants, the formerly much
vaunted firm, Arthur Andersen.
Established economic theory - pioneered by Merton in
1977 - shows that, counterintuitively, the closer a bank is
to insolvency, the more inclined it is to risky lending.
Nobuhiko Hibara of Columbia University demonstrated
this effect convincingly in the Japanese banking system in
his November 2001 draft paper titled "What Happens in
Banking Crises - Credit Crunch vs. Moral Hazard".
Last but by no means least, as opposed to oft-reiterated
wisdom - the markets have no memory. Russia has
egregiously defaulted on its sovereign debt a few times in
the last 100 years. Only seven years ago - in 1998 - it
thumbed its nose with relish at tearful foreign funds,
banks, and investors. Six years later, President Vladimir
Putin dismantled Yukos, the indigenous oil giant and
confiscated its assets, in stark contravention of the
property rights of its shareholders.
Yet, Russia is besieged by investment banks and a horde
of lenders begging it to borrow at concessionary rates. The
same goes for Mexico, Argentina, China, Nigeria,
Thailand, other countries, and the accident-prone banking
system in almost every corner of the globe.
In many places, international aid constitutes the bulk of
foreign currency inflows. It is severely tainted by moral
hazard. In a paper titled "Aid, Conditionality and Moral
Hazard", written by Paul Mosley and John Hudson, and
presented at the Royal Economic Society's 1998 Annual
Conference, the authors wrote:
"Empirical evidence on the effectiveness of both

overseas aid and the 'conditionality' employed by donors
to increase its leverage suggests disappointing results
over the past thirty years ... The reason for both failures
is the same: the risk or 'moral hazard' that aid will be
used to replace domestic investment or adjustment
efforts, as the case may be, rather than supplementing
such efforts."
In a May 2001 paper, tellingly titled "Does the World
Bank Cause Moral Hazard and Political Business
Cycles?" authored by Axel Dreher of Mannheim
University, he responds in the affirmative:
"Net flows (of World Bank lending) are higher prior to
elections ... It is shown that a country's rate of monetary
expansion and its government budget deficit (are)
higher the more loans it receives ... Moreover, the
budget deficit is shown to be larger the higher the
interest rate subsidy offered by the (World) Bank."
Thus, the antidote to moral hazard is not this legendary
beast in the capitalistic menagerie, market discipline. Nor
is it regulation. Nobel Prize winner Joseph Stiglitz,
Thomas Hellman, and Kevin Murdock concluded in their
1998 paper - "Liberalization, Moral Hazard in Banking,
and Prudential Regulation":
"We find that using capital requirements in an economy
with freely determined deposit rates yields ... inefficient
outcomes. With deposit insurance, freely determined
deposit rates undermine prudent bank behavior. To
induce a bank to choose to make prudent investments,
the bank must have sufficient franchise value at risk ...
Capital requirements also have a perverse effect of
increasing the bank's cost structure, harming the
franchise value of the bank ... Even in an economy

where the government can credibly commit not to offer
deposit insurance, the moral hazard problem still may
not disappear."
Moral hazard must be balanced, in the real world, against
more ominous and present threats, such as contagion and
systemic collapse. Clearly, some moral hazard is
inevitable if the alternative is another Great Depression.
Moreover, most people prefer to incur the cost of moral
hazard. They regard it as an insurance premium.
Depositors would like to know that their deposits are safe
or reimbursable. Investors would like to mitigate some of
the risk by shifting it to the state. The unemployed would
like to get their benefits regularly. Bankers would like to
lend more daringly. Governments would like to maintain
the stability of their financial systems.
The common interest is overwhelming - and moral hazard
seems to be a small price to pay. It is surprising how little
abused these safety nets are - as Stephane Pallage and
Christian Zimmerman of the Center for Research on
Economic Fluctuations and Employment in the University
of Quebec note in their paper "Moral Hazard and Optimal
Unemployment Insurance".
Martin Gaynor, Deborah Haas-Wilson, and William Vogt,
cast in doubt the very notion of "abuse" as a result of
moral hazard in their NBER paper titled "Are Invisible
Hands Good Hands?":
"Moral hazard due to health insurance leads to excess
consumption, therefore it is not obvious that competition
is second best optimal. Intuitively, it seems that
imperfect competition in the healthcare market may
constrain this moral hazard by increasing prices. We

show that this intuition cannot be correct if insurance
markets are competitive.
A competitive insurance market will always produce a
contract that leaves consumers at least as well off under
lower prices as under higher prices. Thus, imperfect
competition in healthcare markets can not have
efficiency enhancing effects if the only distortion is due
to moral hazard."
Whether regulation and supervision - of firms, banks,
countries, accountants, and other market players - should
be privatized or subjected to other market forces - as
suggested by the likes of Bert Ely of Ely & Company in
the Fall 1999 issue of "The Independent Review" - is still
debated and debatable. With governments, central banks,
or the IMF as lenders and insurer of last resort - there is
little counterparty risk. Or so investors and bondholders
believed until Argentina thumbed its nose at them in
2003-5 and got away with it.
Private counterparties are a whole different ballgame.
They are loth and slow to pay. Dismayed creditors have
learned this lesson in Russia in 1998. Investors in
derivatives get acquainted with it in the 2001-2 Enron
affair. Mr. Silverstein was agonizingly introduced to it in
his dealings with insurance companies over the September
11 World Trade Center terrorist attacks.
We may more narrowly define moral hazard as the
outcome of asymmetric information - and thus as the
result of the rational conflicts between stakeholders (e.g.,
between shareholders and managers, or between
"principals" and "agents"). This modern, narrow definition
has the advantage of focusing our moral outrage upon the
culprits - rather than, indiscriminately, upon both villains

and victims.
The shareholders and employees of Enron may be entitled
to some kind of safety net - but not so its managers. Laws
- and social norms - that protect the latter at the expense
of the former, should be altered post haste. The
government of a country bankrupted by irresponsible
economic policies should be ousted - its hapless citizens
may deserve financial succor. This distinction between
perpetrator and prey is essential.
The insurance industry has developed a myriad ways to
cope with moral hazard. Co-insurance, investigating
fraudulent claims, deductibles, and incentives to reduce
claims are all effective. The residual cost of moral hazard
is spread among the insured in the form of higher
premiums. No reason not to emulate these stalwart risk
traders. They bet their existence of their ability to
minimize moral hazard - and hitherto, most of them have
been successful.

Note on Regulation
Ultimately, the state is the mother of all insurers, the
master policy, the supreme underwriter. When markets
fail, insurance firm recoil, and financial instruments
disappoint - the government is called in to pick up the
pieces, restore trust and order and, hopefully, retreat more
gracefully than it was forced to enter.
The state would, therefore, do well to regulate all financial
instruments: deposits, derivatives, contracts, loans,
mortgages, and all other deeds that are exchanged or
traded, whether publicly (in an exchange) or privately.
Trading in a new financial instrument should be allowed
only after it was submitted for review to the appropriate
regulatory authority; a specific risk model was
constructed; and reserve requirements were established
and applied to all the players in the financial services
industry, whether they are banks or other types of
intermediaries.
Note on Risk Aversion
Why are the young less risk-averse than the old?
One standard explanation is that youngsters have less to
lose. Their elders have accumulated property, raised a
family, and invested in a career and a home. Hence their
reluctance to jeopardize it all.
But, surely, the young have a lot to forfeit: their entire
future, to start with. Time has money-value, as we all
know. Why doesn't it factor into the risk calculus of young
people?
It does. Young people have more time at their disposal in

which to learn from their mistakes. In other words, they
have a longer horizon and, thus, an exponentially
extended ability to recoup losses and make amends.
Older people are aware of the handicap of their own
mortality. They place a higher value on time (their
temporal utility function is different), which reflects its
scarcity. They also avoid risk because they may not have
the time to recover from an erroneous and disastrous
gamble.
Also Read:
The Business of Risk
Return

The Agent-Principal Conundrum
In the catechism of capitalism, shares represent the partownership of an economic enterprise, usually a firm. The
value of shares is determined by the replacement value of
the assets of the firm, including intangibles such as
goodwill. The price of the share is determined by
transactions among arm's length buyers and sellers in an
efficient and liquid market. The price reflects expectations
regarding the future value of the firm and the stock's
future stream of income - i.e., dividends.
Alas, none of these oft-recited dogmas bears any
resemblance to reality. Shares rarely represent ownership.
The float - the number of shares available to the public - is
frequently marginal. Shareholders meet once a year to
vent and disperse. Boards of directors are appointed by
management - as are auditors. Shareholders are not
represented in any decision making process - small or big.
The dismal truth is that shares reify the expectation to find
future buyers at a higher price and thus incur capital gains.
In the Ponzi scheme known as the stock exchange, this
expectation is proportional to liquidity - new suckers - and
volatility. Thus, the price of any given stock reflects
merely the consensus as to how easy it would be to
offload one's holdings and at what price.
Another myth has to do with the role of managers. They
are supposed to generate higher returns to shareholders by
increasing the value of the firm's assets and, therefore, of
the firm. If they fail to do so, goes the moral tale, they are

booted out mercilessly. This is one manifestation of the
"Principal-Agent Problem". It is defined thus by the
Oxford Dictionary of Economics:
"The problem of how a person A can motivate person B to
act for A's benefit rather than following (his) selfinterest."
The obvious answer is that A can never motivate B not to
follow B's self-interest - never mind what the incentives
are. That economists pretend otherwise - in "optimal
contracting theory" - just serves to demonstrate how
divorced economics is from human psychology and, thus,
from reality.
Managers will always rob blind the companies they run.
They will always manipulate boards to collude in their
shenanigans. They will always bribe auditors to bend the
rules. In other words, they will always act in their selfinterest. In their defense, they can say that the damage
from such actions to each shareholder is minuscule while
the benefits to the manager are enormous. In other words,
this is the rational, self-interested, thing to do.
But why do shareholders cooperate with such corporate
brigandage? In an important Chicago Law Review article
whose preprint was posted to the Web a few weeks ago titled "Managerial Power and Rent Extraction in the
Design of Executive Compensation" - the authors
demonstrate how the typical stock option granted to
managers as part of their remuneration rewards mediocrity
rather than encourages excellence.
But everything falls into place if we realize that
shareholders and managers are allied against the firm - not
pitted against each other. The paramount interest of both

shareholders and managers is to increase the value of the
stock - regardless of the true value of the firm. Both are
concerned with the performance of the share - rather than
the performance of the firm. Both are preoccupied with
boosting the share's price - rather than the company's
business.
Hence the inflationary executive pay packets.
Shareholders hire stock manipulators - euphemistically
known as "managers" - to generate expectations regarding
the future prices of their shares. These snake oil salesmen
and snake charmers - the corporate executives - are
allowed by shareholders to loot the company providing
they generate consistent capital gains to their masters by
provoking persistent interest and excitement around the
business. Shareholders, in other words, do not behave as
owners of the firm - they behave as free-riders.
The Principal-Agent Problem arises in other social
interactions and is equally misunderstood there. Consider
taxpayers and their government. Contrary to conservative
lore, the former want the government to tax them
providing they share in the spoils. They tolerate
corruption in high places, cronyism, nepotism, inaptitude
and worse - on condition that the government and the
legislature redistribute the wealth they confiscate. Such
redistribution often comes in the form of pork barrel
projects and benefits to the middle-class.
This is why the tax burden and the government's share of
GDP have been soaring inexorably with the consent of the
citizenry. People adore government spending precisely
because it is inefficient and distorts the proper allocation
of economic resources. The vast majority of people are
rent-seekers. Witness the mass demonstrations that erupt
whenever governments try to slash expenditures,

privatize, and eliminate their gaping deficits. This is one
reason the IMF with its austerity measures is universally
unpopular.
Employers and employees, producers and consumers these are all instances of the Principal-Agent Problem.
Economists would do well to discard their models and go
back to basics. They could start by asking:
Why do shareholders acquiesce with executive
malfeasance as long as share prices are rising?
Why do citizens protest against a smaller government even though it means lower taxes?
Could it mean that the interests of shareholders and
managers are identical? Does it imply that people prefer
tax-and-spend governments and pork barrel politics to the
Thatcherite alternative?
Nothing happens by accident or by coercion. Shareholders
aided and abetted the current crop of corporate executives
enthusiastically. They knew well what was happening.
They may not have been aware of the exact nature and
extent of the rot - but they witnessed approvingly the
public relations antics, insider trading, stock option
resetting , unwinding, and unloading, share price
manipulation, opaque transactions, and outlandish pay
packages. Investors remained mum throughout the
corruption of corporate America. It is time for the
hangover.

Trading in Sovereign Promises
Martin Schubert and his New-York (now Miami) based
investment boutique, European Inter-American Finance,
in joint venture with Merrill Lynch and Aetna, pioneered
the private trading of sovereign obligations of emerging
market economies, including those in default. In
conjunction with private merchant banks, such as Singer
Friedlander in the United Kingdom, he conjured up
liquidity where there was none and captured the
imagination of businesses on both sides of the Atlantic.
Today, his vision is vindicated by the proliferation of
ventures similar to his and by the institutionalization of
the emerging economies sovereign debt market. Even
obligations of countries such as Serbia and Iraq are traded,
though sporadically. Recently, according to Dow Jones,
Iraqi debt doubled itself and is now changing hands at
about 15 to 20 cents to the dollar.
The demand is so overwhelming that Geneva-based
brokerage firm Trigone Capital Finance created a special
fund to provide interested investors with exposure to Iraqi
paper. Nor is the enthusiasm confined to this former
member of the axis of evil. Yugoslav debt is firm at 50
cents, despite recent political upheavals, including the
assassination of the reformist and pro-Western prime
minister.
Emerging market sovereign debts are irresistible. Some of
them now yield 1000 basis points above comparable US
Treasuries. The mean spread, according to JP Morgan's
Emerging Markets Bond Index Plus is c. 600 points.
Corporate securities are even further in the stratosphere.

But with frenzied buying all around, returns have been
declining precipitously in the last few weeks. Investors in
emerging market bonds saw average profits of 10 percent
this year - masking a surge of 30 percent in Brazilian and
Ecuadorian paper, for instance. JP Morgan Chase's EMBI
Global index is up 19 percent since September 2002.
Nor is this a new trend. The EMBI Global Index has
witnessed in each of the last four years an average gain of
14 percent. According to Bloomberg, the assets of
emerging market debt funds surged by one tenth since the
beginning of the year, or $948 million - compared to $648
received during throughout last year.
The party is on. Emerging market debt is either traded on
various exchanges or brokered privately to wealthy or
institutional clientele. The obligations fall into categories
too numerous to mention: insured and uninsured credits,
defaulted or performing, corporate against municipal or
sovereign and so on.
A dominant class of obligations is called "Brady bonds"
after the former U.S. Treasury Secretary Nicholas Brady.
These securities are the outcomes of the rescheduling pf
commercial bank loans (sometimes defaulted) to
developing nations. The principal of the rescheduled debt
- guaranteed by U.S. zero coupon Treasuries deposited by
the original issuer in the Federal Reserve or some other
credible institution - remains to be fully paid. The interest
accrued on the principal until the moment of rescheduling
is reduced and the term of payment is prolonged.
Brady countries include Venezuela, Brazil, Argentina,
Ecuador and Mexico, to name just a few. The bonds have
been trading since 1989. Only one Brady bond has ever
defaulted (Ecuador). No interest payment was ever missed

or skipped.
As Nazibrola Lordkipanidze and Glenn C. W. Ames
observe in their paper, "Hedging Emerging Market Debt",
the terms of individual Brady packages vary. Individual
countries have issued as few as one, and as many as eight
different bonds, each of which can vary with respect to
maturity, fixed or floating coupons, amortization
schedules, and the degree to which principal and interest
payments are collateralized.
The market is besieged by - mostly offshore - mutual
funds managed by the likes of Pacific Investment
Management Company (PIMCO), AllianceBernstein,
Scudder Investments, MFS Investment Management and
Mainstay Investment Management.
Emerging market debt attracted entrepreneurial fund
managers who set up nimble and agile shop. Ashmore
Investment Management was divested to its current
owners by Australia & New Zealand Banking Group.
Despite the obvious shortcomings of its size - limited
access to information and research - it runs a successful
Russian fund, among others.
When the United Kingdom based firms, Garban Securities
and Intercapital Securities, merged late in 1999, they
transferred their illiquid emerging market securities
businesses into a common vehicle, Exotix. The new
outfit's team was poached from the trading side of
emerging markets divisions of various investment banks.
Exotix brokers the purchase and sale of fixed income
products from risky countries.
Maxcor Financial, a broker-dealer subsidiary of Maxcor
Financial Group, is an inter-dealer broker of various

securities products, including emerging market debt. It
also conducts institutional sales and trading operations in
high yield and distressed debt. AIG Trading, of the AIG
group, maintains a full-fledged emerging markets team. It
boasts of "senior level contacts within many central
banks, allowing us to provide rare insight".
Other outfits stay out of the limelight and offer discrete
services, custom-tailored to the needs of particular clients.
The Weston Group, in operation since 1988, is active in
the Mexican market. It does underwriting, private
placements and structured finance.
Companies such as Omni Whittington have specialized in
"debt recovery" - the placement and conversion of
defaulted bank and trade debt from political risk countries.
They buy bad debt through a dedicated investment fund,
collect on non-performing credits (on a "no cure, no pay"
basis) and manage portfolios of loans gone sour, including
the negotiation of their rescheduling.
Vulture funds are financial firms that purchase sovereign
debt at a considerable disaggio and then demand full
payment from the issuing country. A single transaction
with a solitary series of heavily discounted promissory
notes can wipe out the entire benefit afforded by muchtouted international debt relief schemes and obstruct debt
rescheduling efforts.
One sure sign of this niche's growing importance is the
proliferation of conferences, consultancies, seminars,
trade publications and books. Banks and law and
accounting firms have set up dedicated departments to
tackle the juridical and commercial intricacies of
defaulted debt, both corporate and sovereign. International
law is adapting itself through a growing body of

legislation and precedents. Moody's Investors Service,
Standard & Poor's and Fitch regularly rate emerging
market issues.
RBC Investment Services (Asia), a business unit of the
Royal Bank Financial Group, a Canadian investment
bank, advises its clients in their investments in Bradys.
Union des Banques Arabes et Francaises, 44 percent
owned by Credit Lyonnais and the rest by Arab banks,
including the Iraqi Rafidain, is an aggressive buyer of
Iraqi and other Middle Eastern debt.
But the market is still immature and inefficient. In an
address to the Sovereign Debt Restructuring Mechanism
Conference earlier this year, Kenneth Rogoff, Research
Director of the International Monetary Fund surveyed the
scorched landscape:
"Private debt flows to emerging markets (produce) wild
booms, spectacular crashes, over indebtedness, excessive
reliance on short-term and foreign-currency denominated
debt, and protracted stagnation following a debt crisis.
Emerging economies' governments ... sometimes borrow
more than is good for their citizens (and are) ... sometimes
willing to take on excessive risk to save on interest costs.
On the investor side, there is often a reluctance to hold
instruments that would provide for more flexibility and
risk sharing, such as GDP-indexed bonds, domestic
equity, and local currency debtâ&#x20AC;&#x201D;in part, because of poor
policy credibility and weak domestic institutions. The
result is an excessive reliance on 'dangerous' forms of
debt, such as foreign-currency denominated debt and
short-term debt, which aggravate the pain of crises when
they occur."
Weak property rights, uncertain debt recovery

mechanisms, political risks, excessive borrowing,
collective action problems among creditors and moral
hazard are often associated with credit-insatiable
emerging economies, failed states, erstwhile empires,
developing countries and polities in transition.
Signs of trouble abound from Turkey to Bolivia and from
Paraguay to Africa. Nigerian President Olusegun
Obasanjo said last July that paying civil servants was
more important than avoiding default on the country's $30
billion debt. Its Supreme Court ruled in April 2002 that it
is unconstitutional to pay down the external debt before
all other government expenses. Nor would that be the first
time Nigeria reneges. The Paris Club of creditor countries
has been rescheduling its debts repeatedly.
This is not to mention Argentina. Its corporate sector
missed $4.6 billion in payments in the last six months
alone and the country defaulted on a whopping $95 billion
in obligations. The conduct of debtors, transparency and
accountability are not improving either. Russia all but
withheld information regarding a French lawsuit in a plan
to swap $3.1 billion in new Eurobonds for about $6 billion
of defaulted Soviet-era debt.
The status of creditors is under further strains by the
repeated floating of schemes to put in place some kind of
sovereign bankruptcy mechanism. The Bush
administration proposed to modify all sovereign debt
contracts pertaining to all forms of debt to allow for
majority decision making, the pro-rata sharing of
disproportionate payments received by one creditor
among all others and structured, compulsory discussions
led by creditor committees.
The IMF's First Deputy Managing Director, Anne

Krueger, countered, in November 2001, with the idea to
allow countries to go bankrupt within a Sovereign Debt
Restructuring Mechanism (SDRM). Legal action by
creditors will be "stayed" while the country gets its
financial affairs in order and obtains supplemental
funding. Such an approach makes eminent sense.
In opening remarks to the Council of the Americas in
November 2001, Martin Schubert offered these
observations:
"Talk of adopting bankruptcy procedure protection for
governments ... similar to that employed by private
companies, could be the match that lights the fire, due to
the conflicts such a standstill would create. Moreover,
what government debtor would be willing or able to
assign assets to a trustee or assignee in bankruptcy, for the
benefit of creditors?"
But investors never learn. In a world devoid of attractive
investment options, they keep ploughing their money into
the high-yield scenes of financial crimes committed
against them. This self-defeating tendency is reinforced by
the general stampede from equities to bonds and by the
slow-motion implosion of the US dollar, partly as a result.
Until the next major default, that is.
Also Read:
The Bankrupt Sovereign
The Demonetization of the East
O'Neill's Free Dinner - America's Current Account
Deficit
The Delicate Art of Balancing the Budget

Economic Management in a State of War
Governments and Growth
Iraq's Reconstruction - Payback Time

Return

Portfolio Management Theory
And Technical Analysis
Lecture Notes
The Bill of Rights of the Investor
1. To earn a positive return (=yield) on their capital.
2. To insure his investments against risks (=to hedge).
3. To receive information identical to the that of ALL
other investors - complete, accurate and timely and to
form independent judgement based on this information.
4.To alternate between investments - or be compensated
for diminished liquidity.
5. To study how to carefully and rationally manage his
portfolio of investments.
6.To compete on equal terms for the allocation of
resources.
7. To assume that the market is efficient and fair.

RISK
1. The difference between asset-owners, investors and
speculators.
2. Income: general, free, current, projected (expectations),
certain, uncertain.
3. CASE A (=pages 3 and 4)
4. The solutions to our FIRST DISCOVERY are called:
"The Opportunities Set"
5. The "INDIFFERENCE CURVE" or the "UTILITY
CURVE"
{SHOW THREE DIAGRAMS}
6. The OPTIMAL SOLUTION (=maximum consumption
in both years).
7. The limitations of the CURVES:
a. More than one investment alternative;
b. Future streams of income are not certain;
c. No investments is riskless;
d. Risk=uncertainty;
e. FREQUENCY FUNCTIONS.
8. CASE B

CASE A
INVESTOR A has secured income of $20,000 p.a. for the
next 2 years.
One investment alternative: a savings account yielding 3%
p.a.
(in real terms = above inflation or inflation adjusted).
One borrowing alternative: unlimited money at 3%
interest rate
(in real terms = above inflation or inflation adjusted).
MR. SPENDER
Will spend $20,000 in year 1
and $20,000 in year 2
and save $ 0
MR. SPENDTHRIFT
Will save $20,000 in year 1 (=give up his liquidity)
and spend this money
plus 3% interest $600
plus $20,000 in year 2 (=$40,600)

MR. BIG PROBLEM
Will spend $20,000 in year 1
plus lend money against his income in year 2
He will be able to lend from the banks a maximum of:
$19,417 (+3% = $20,000)
HIDDEN ASSUMPTIONS IN MR. BIG PROBLEM's
CASE:
1. That he will live on long enough to pay back his
debts.
2. That his income of $20,000 in the second year is
secure.
3. That this is a stable, certain economy and,
therefore, interest rates will remain at the same
level.
THE CONCEPT OF NET PRESENT VALUE
Rests on the above three assumptions (Keynes' theorem
about the long run).
$19,417 is the NPV of $20,000 in one year with 3%.
OUR FIRST DISCOVERY:
THE CONSUMPTION IN THE SECOND YEAR =
THE INCOME IN THE SECOND YEAR +
{Money Saved in the First Year X (1 + the interest
rate)}
CASE B

1. The concept of scenarios (Delphi) and probabilities
2. THE MEAN VALUE OF AN ASSET's YIELD =
SUM {YIELDS IN DIFFERENT SCENARIOS X
PROBABILITIES OF THE SCENARIOS}
{SHOW TABLE - p14}
3. The properties of the Mean Value:
4. The mean of the multiplications of a Constant in the
yields equals the multiplication of the Constant in the
Mean Value of the yields.
5. The Mean of the yields on two types of assets = The
Sum of the Means of each asset calculated separately
{SHOW TABLE - p16}
6. Bi-faceted securities: the example of a convertible
bond.
{SHOW TABLE - p16}
7. VARIANCE and STANDARD DEVIATION as
measures of the difference between mathematics and
reality.
They are the measures of the frustration of our
expectations.
{Calculation - p17}

8. THE RULE OF PREFERENCE:
We will prefer a security with the highest Mean Value plus
the lowest Standard Deviation.
9. The PRINCIPLE OF DIVERSIFICATION of the
investment portfolio: The Variance of combined assets
may be less than the variance of each asset separately.
{Calculation - p18}
10. THE FOUR PILLARS OF DIVERSIFICATION:
a. The yield provided by an investment in a portfolio
of assets will be closer to the Mean Yield than an
investment in a single asset.
b. When the yields are independent - most yields will
be concentrated around the Mean.
c. When all yields react similarly - the portfolio's
variance will equal the variance of its underlying
assets.
d. If the yields are dependent - the portfolio's
variance will be equal to or less than the lowest
variance of one of the underlying assets.
11. Calculating the Average Yield of an Investment
Portfolio.
{Calculation - pp. 18 - 19}
12. Short - cutting the way to the Variance:
PORTFOLIO COVARIANCE - the influence of events
on the yields of underlying assets.
{Calculation - p19}
13. Simplifying the Covariance - the Correlation
Coefficient.
{Calculation - p19}
14. Calculating the Variance of multi-asset investment
portfolios.

3. The Quasi - Rigorous Test: Is all the publicly available
information fully reflected in the current price of a share?
4. The Rigorous Test: Is all the (publicly and privately)
available information fully reflected in the current price of
a share?
5. A positive answer would prevent situations of excess
yields.
6. The main question: how can an investor increase his
yield (beyond the average market yield) in a market where
all the information is reflected in the price?
7. The Lenient version: It takes time for information to be
reflected in prices.
Excess yield could have been produced in this time - had
it not been so short.
The time needed to extract new information from prices =
The time needed for the information to be reflected.
The Lenient Test: will acting after the price has changed provide excess yield.
8. The Quasi - Rigorous version: A new price (slightly
deviates from equilibrium) is established by buyers and
sellers when they learn the new information.
The QR Test: will acting immediately on news provide
excess yield?
Answer: No. On average, the investor will buy at
equilibrium convergent price.
9. The Rigorous version: Investors cannot establish the
"paper" value of a firm following new information.
Different investors will form different evaluations and

will act in unpredictable ways. This is "The Market
Mechanism". If a right evaluation was possible - everyone
would try to sell or buy at the same time.
The Rigorous Test: Is it at all possible to derive excess
yield from information? Is there anyone who received
excess yields?
10. New technology for the dissemination of information,
professional analysis and portfolio management and strict
reporting requirements and law enforcement - support the
Rigorous version.
11. The Lenient Version: Analysing past performance
(=prices) is worthless.
The QR Version: Publicly available information is
worthless.
The Rigorous version: No analysis or portfolio
management is worth anything.
12. The Fair Play Theorem: Since an investor cannot
predict the equilibrium, he cannot use information to
evaluate the divergence of (estimated) future yields from
the equilibrium. His future yields will always be
consistent with the risk of the share.
13. Insider - Trading and Arbitrageurs.
14. Price predictive models assume:
(a) The yield is positive and (b) High yield is associated
with high risk.
15. Assumption (a) is not consistent with the Lenient
Version.
16. Random Walk Theory (RWT):

a. Current share prices are not dependent on
yesterday's or tomorrow's prices.
b. Share prices are equally distributed over time.
17. The Monte Carlo Fallacy and the Stock Exchange (no
connection between colour and number).
18. The Fair Play Theorem does not require an equal
distribution of share prices over time and allows for the
possibility of predicting future prices (e.g., a company
deposits money in a bank intended to cover an increase in
its annual dividends).
19. If RWT is right (prices cannot be predicted) - the
Lenient Version is right (excess yields are impossible).
But if the Lenient Version is right - it does not mean that
RWT is necessarily so.
20. The Rorschach tendency to impose patterns (cycles,
channels) on totally random graphic images.
The Elton - Gruber experiments with random numbers
and newly - added random numbers.
No difference between graphs of random numbers - and
graphs of share prices.
21. Internal contradiction between assumption of
"efficient market" and the ability to predict share prices,
or price trends.
22. The Linear Model
P = Price of share; C = Counter; ED P = Expected
difference (change) in price
DP = Previous change in price; R = Random number

Pa - Pa-1 = ( ED P + D P/ ED P ) 路 ( Pa-1-c - Pa-2-c + R )
Using a correlation coefficient.
23. The Logarithmic Model
( log CPn ) / ( log CPn-1 ) = Cumulative yield CP =
Closing Price
Sometimes instead of CP, we use: D P / (div/P) D P =
Price change div = dividend
24. These two models provide identical results - and they
explain less than 2% of the change in share prices.
25. To eliminate the influence of very big or small
numbers - some analyse only the + and - signs of the price
changes
Fama and Macbeth proved the statistical character of sign
clusters.
26. Others say that proximate share prices are not
connected - but share prices are sinusoidally connected
over time.
Research shows faint traces of seasonality.
27. Research shows that past and future prices of shares
are connected with transaction costs. The higher the costs
- the higher the (artificial) correlation (intended to, at
least, cover the transaction costs).
28. The Filter (Technical Analysis) Model
Sophisticated investors will always push prices to the
point of equilibrium.
Shares will oscillate within boundaries. If they break
them, they are on the way to a new equilibrium. It is a
question of timing.

29. Is it better to use the Filter Model or to hold onto a
share or onto cash?
Research shows: in market slumps, continuous holders
were worse off than Filter users and were identical with
random players.
This was proved by using a mirror filter.
30. The filter Model provides an excess yield identical to
transaction costs.
Fama - Blum: the best filter was 0,5%. For the purchase
side -1%, 1,5%.
Higher filters were better than constant holding ("Buy and
Hold Strategy") only in countries with higher costs and
taxes.
31. Relative Strength Model
( CP ) / ( AP ) = RS CP = Current price AP = Average in X
previous weeks
a. Divide investment equally among highest
RS shares.
b. Sell a share whose RS fell below the RS' of
X% of all shares Best performance is
obtained when: "highest RS" is 5% and
X% = 70%.
32. RS models instruct us to invest in upwardly volatile
stocks - high risk.
33. Research: RS selected shares (=sample) exhibit yields
identical to the Group of stocks it was selected from.
When risk adjusted - the sample's performance was
inferior (higher risk).

34. Short term movements are more predictable.
Example: the chances for a reverse move are 2-3 times
bigger than the chances for an identical one.
35. Brunch: in countries with capital gains tax - people
will sell losing shares to materialize losses and those will
become underpriced.
They will correct at the beginning of the year but the
excess yield will only cover transaction costs, (The
January effect).
36. The market reacts identically (=efficiently) to all
forms of information.
37. Why does a technical operation (split / reverse split)
influence the price of the share (supposed to reflect
underlying value of company)?
Split - a symptom of changes in the company. Shares go
up before a split was conceived - so split is reserved for
good shares (dividend is increased). There is excess yield
until the split - but it is averaged out after it.
38. There is considerable gap (upto 2 months) between the
announcement and the split. Research shows that no
excess yield can be obtained in this period.
39. The same for M & A
40. The QR Version: excess yields could be made on
private information.
Research: the influence of Wall Street Journal against the
influence of market analyses distributed to a select public.
WSJ influenced the price of the stocks - but only that day.
41. The Rigorous Version: excess yields cannot be made
on insider information.

How to test this - if we do not know the information?
Study the behaviour of those who have (management, big
players).
Research shows that they do achieve excess yields.
42. Do's and Don'ts
a. Select your investments on economic grounds.
Public knowledge is no advantage.
b. Buy stock with a disparity and discrepancy
between the situation of the firm - and the
expectations and appraisal of the public
(Contrarian approach vs. Consensus approach).
c. Buy stocks in companies with potential for
surprises.
d. Take advantage of volatility before reaching a new
equilibrium.
e. Listen to rumours and tips, check for yourself.
Profitability and Share Prices
1. The concept of a the business firm - ownership,
capital and labour.
2. Profit - the change in an assets value (different
forms of change).
3. Financial statements: Balance Sheet, PNL, Cash
Flow, Consolidated - a review.
4. The external influences on the financial statements
- the cases of inflation, exchange rates,
amortization / depreciation and financing

expenses.
5. The correlation between share price performance
and profitability of the firms.
6. Market indicators: P/E, P/BV (Book Value).
7. Predicting future profitability and growth.
Bonds
1. The various types of bonds: bearer and named;
2. The various types of bonds: straight and
convertible;
3. The various types of bonds (according to the
identity of the issuer);
4. The structure of a bond: principal (face), coupon;
5. Stripping and discounting bonds;
6. (Net) Present Value;
7. Interest coupons, yields and the pricing of bonds;
8. The Point Interest Rate and methods for its
calculation (discrete and continuous);
9. Calculating yields: current and to maturity;
10. Summing up: interest, yield and time;
11. Corporate bonds;
12. Taxation and bond pricing;
13. Options included in the bonds.

PAR = Principal payment
n = number of payments
5. BOND CONVEXITY - an increase in interest rates
results in a price decline that is smaller than the price gain
resulting from a decrease of equal magnitude in interest
rates.

a. Duration of zero coupon bond = its time to
maturity.
b. When maturity is constant, a bond's duration is
higher when the coupon rate is lower.
c. When the coupon rate is constant, a bond's
duration increases with its time to maturity.
Duration always increases with maturity for bonds
selling at par or at a premium.
With deeply discounted bonds duration decreases
with maturity.
d. Other factors being constant, the duration of a
coupon bond is higher when the bond's YTM is
lower.
e. The duration of a level perpetuity = 1+y / y
f. The duration of a level annuity = 1+y/y - T/(1+y)T
-1
g. The duration of a coupon bond = 1+y/y (1+y)+T(c-y) / c[(1+y)T-1]+y
h. The duration of coupon bonds selling at par values
= {1+y/y Â´ [1 - 1/(1+y)T]} Â´ 100
9. Passive bond management - control of the risk, not of
prices.
- indexing (market risk)
- immunization (zero risk)
10. Some are interested in protecting the current net worth
- others with payments (=the future worth).
11. BANKS: mismatch between maturities of liabilities

a. Substitution swap - replacing one bond with
identical one.
b. Intermarket spread swap - when the yield spread
between two sectors of the bond market is too
wide.
c. Rate anticipation swap - changing duration
according to the forecasted interest rates.
d. Pure yield pickup swap - holding higher yield
bond.
e. Tax swap - intended to exploit tax advantages.
22. Contingent immunization (Leibowitz - Weinberger):
Active management until portfolio drops to
minimum future value / (1+I)T = Trigger value
if portfolio drops to trigger value - immunization.
23. Horizon Analysis
Select a Holding Period
Predict the yield curve at the end of that period
[We know the bond's time to maturity at the end of the
holding period]
{We can read its yield from the yield curve} determine
price
24. Riding the yield curve
If the yield curve is upward sloping and it is projected not
to shift during the investment horizon as maturities fall
(=as time passes) - the bonds will become shorter - the
yields will fall - capital gains

William Sharpe, John Lintner, Jan Mossin
1. Capital Asset Pricing Model (CAPM) predicts the
relationship between an asset's risk and its expected return
= benchmark rate of return (investment evaluation) =
expected returns of assets not yet traded
2. Assumptions
[Investors are different in wealth and risk aversion} but:
a. Investor's wealth is negligible compared to the
total endowment;
b. Investors are price - takers (prices are unaffected
by their own trade);
c. All investors plan for one, identical, holding
period (myopic, suboptimal behaviour);
d. Investments are limited to publicly traded financial
assets and to risk free borrowing / lending
arrangements;
e. No taxes on returns, no transaction costs on trades;
f. Investors are rational optimizers (mean variance Markowitz portfolio selection model);
g. All investors analyse securities the same way and
share the same economic view of the world 速
homogeneous expectations identical estimates of
the probability distribution of the future cash flows
from investments.
3. Results
a. All the investors will hold the market portfolio.

b. The market portfolio is the best, optimal and
efficient one.
A passive (holding) strategy is the best.
Investors vary only in allocating the amount
between risky and risk - free assets.
c. The risk premium on the market portfolio will be
proportional to:
its risk
and the investor's risk aversion
d. The risk premium on an individual asset will be
proportional to the risk premium on the market
portfolio
and the beta coefficient of the asset (relative to the
market portfolio).
Beta measures the extent to which returns on the stock
and the market move together.
4. Calculating the Beta
a. The graphic method
The line from which the sum of standard
deviations of returns is lowest.
The slope of this line is the Beta.
b. The mathematical method
짜짜
bi = Cov (ri, rm) / sm2 = S (yti-yai)(ytm-yam) / S (ytmtam)2
t=1 t=1

5. Restating the assumptions
a. Investors are rational
b. Investors can eliminate risk by diversification
- sectoral
- international
c. Some risks cannot be eliminated - all investments
are risky
d. Investors must earn excess returns for their risks
(=reward)
e. The reward on a specific investment depends only
on the extent to which it affects the market
portfolio risk (Beta)
6. Diversified investors should care only about risks
related to the market portfolio.
Return

Beta
1/2 1 2
Investment with Beta 1/2 should earn 50% of the market's
return
with Beta 2 - twice the market return.
7. Recent research discovered that Beta does not work.
A better measure:
B/M
(Book Value) / (Market Value)
8. If Beta is irrelevant - how should risks be measured?
9. NEER (New Estimator of Expected Returns):
The B to M ratio captures some extra risk factor and
should be used with Beta.

10. Other economists: There is no risk associated with
high B to M ratios.
Investors mistakenly underprice such stocks and so they
yield excess returns.
11. FAR (Fundamental Asset Risk) - Jeremy Stein
There is a distinction between:
a. Boosting a firm's long term value and
b. Trying to raise the share's price
If investors are rational:
Beta cannot be the only measure of risk 速 we should stop
using it
Any decision boosting (A) will affect (B) 速 (A) and (B)
are the same
If investors are irrational
Beta is right (it captures an asset's fundamental risk = its
contribution to the market portfolio risk) 速 we should use
it, even if investors irrational if investors are making
predictable mistakes - a manager must choose:
If he wants (B) 速 NEER (accommodating investors
expectations)
If he wants (A) BETA
TECHNICAL ANALYSIS - Part A
1. Efficient market hypothesis - share prices reflect all
available information

2. Weak form
Are past prices reflected in present prices?
No price adjustment period - no chance for abnormal
returns
(prices reflect information in the time that it takes to
decipher it from them)
If we buy after the price has changed - will we have
abnormal returns?
Technical analysis is worthless
3. Semistrong form
Is publicly available information fully reflected in present
prices?
Buying price immediately after news will converge, on
average, to equilibrium
Public information is worthless
4. Strong form
Is all information - public and private - reflected in
present prices?
No investor can properly evaluate a firm
All information is worthless
5. Fair play - no way to use information to make abnormal
returns
An investor that has information will estimate the yield
and compare it to the equilibrium yield. The deviation of
his estimates from equilibrium cannot predict his actual
yields in the future.

R = Random number
14. The Logarithmic model
= cum. Y
Sometimes, instead of Pc we use D P +
15. Cluster analysis (Fama - Macbeth)
+ and - distributed randomly. No statistical significance.
16. Filter models - share prices will fluctuate around
equilibrium because of profit taking and bargain hunting
17. New equilibrium is established by breaking through
trading band
18. Timing - percentage of break through determines buy /
sell signals
19. Filters effective in BEAR markets but equivalent to
random portfolio management
20. Fama - Blum: best filter is the one that covers
transaction costs
21. Relative strength models - P / P
Divide investment equally between top 5% of shares with
highest RS and no less than 0,7
Sell shares falling below this benchmark and divide the
proceeds among others
22. Reservations:
a. High RS shares are the riskiest
b. The group selected yield same as market - but with higher risk

TECHNICAL ANALYSIS - Part B
1. Versus fundamental: dynamic (trend) vs. static (value)
2. Search for recurrent and predictable patterns
3. Patterns are adjustment of prices to new information
4. In an efficient market there is no such adjustment, all
public information is already in the prices
5. The basic patterns:
a. momentum
b. breakaway
c. head and shoulders 速 chartists
6. Buy/sell signals
Example: Piercing the neckline of Head and Shoulders
7. The Dow theory uses the Dow Jones industrial average
(DJIA) as key indicator of underlying trends +
DJTransportation as validator
8. Primary trend - several months to several years
Secondary (intermediate) trend - deviations from primary
trend: 1/3, 1/2, 2/3 of preceding primary trend
Correction - return from secondary trend to primary trend
Tertiary (minor) trend - daily fluctuations
9. Channel - tops and bottoms moving in the direction of
primary trend
10. Technical analysis is a self fulfilling prophecy - but if

everyone were to believe in it and to exploit it, it would
self destruct.
People buy close to resistance because they do not believe
in it.
11. The Elliott Wave theory - five basic steps, a fractal
principle
12. Moving averages - version I - true value of a stock is
its average price
prices converge to the true value
version II - crossing the price line with the moving
average line predicts future prices
13. Relative strength - compares performance of a stock to
its sector or to the performance of the whole market
14. Resistance / support levels - psychological boundaries
to price movements assumes market price memory
15. Volume analysis - comparing the volume of trading to
price movements high volume in upturns, low volume in
down movements - trend reversal
16. Trin (trading index) =
Trin > 1 Bearish sign
17. BEAR / Bull markets - down/up markets disturbed by
up/down movements
18. Trendline - price moves upto 5% of average
19. Square - horizontal transition period separating price
trends (reversal patterns)
20. Accumulation pattern - reversal pattern between

BEAR and BULL markets
21. Distribution pattern - reversal pattern between BULL
and BEAR markets
22. Consolidation pattern - if underlying trends continues
23. Arithmetic versus logarithmic graphs
24. Seasaw - non breakthrough penetration of resistance /
support levels
25. Head and shoulder formation (and reverse formation):
Small rise (decline), followed by big rise (decline),
followed by small rise (decline).
First shoulder and head-peak (trough) of BULL (BEAR)
market.
Volume very high in 1st shoulder and head and very low
in 2nd shoulder.
26. Neckline - connects the bottoms of two shoulders.
Signals change in market direction.
27. Double (Multiple) tops and bottoms
Two peaks separated by trough = double tops
Volume lower in second peak, high in penetration
The reverse = double bottoms
28. Expanding configurations
Price fluctuations so that price peaks and troughs
can be connected using two divergent lines.
Shoulders and head (last).

Sometimes, one of the lines is straight:
UPPER (lower down) or - accumulation, volume in
penetration
LOWER (upper up) 5% penetration signals reversal
29. Conservative upper expanding configuration
Three tops, each peaking
Separated by two troughs, each lower than the other
Signals peaking of market
5% move below sloping trendline connecting two troughs
or below second through signals reversal
30. Triangles - consolidation / reversal patterns
31. Equilateral and isosceles triangle (COIL - the opposite
of expansion configuration)
Two (or more) up moves + reactions
Each top lower than previous - each bottom higher than
previous
connecting lines converge
Prices and volume strongly react on breakthrough
32. Triangles are accurate when penetration occurs
Between 1/2 - 3/4 of the distance between the most
congested peak and the highest peak.
33. Right angled triangle
Private case of isosceles triangle.
Often turn to squares.

34. Trendlines
Connect rising bottoms or declining tops (in Bull market)
Horizontal trendlines
35. Necklines of H&S configurations
And the upper or lower boundaries of a square are
trendlines.
36. Upward trendline is support
Declining trendline is resistance
37. Ratio of penetrations to number of times that the
trendline was only touched without being penetrated
Also: the time length of a trendline
the steepness (gradient, slope)
38. The penetration of a steep trendline is less meaningful
and the trend will prevail.
39. Corrective fan
At the beginning of Bull market - first up move steep,
price advance unsustainable.
This is a reaction to previous downmoves and trendline
violated.
New trendline constructed from bottom of violation
(decline) rises less quickly, violated.
A decline leads to third trendline.
This is the end of the Bull market
(The reverse is true for Bear market.)
40. Line of return - parallel to upmarket trendline,

Schemes Challenged
The credit and banking crisis of 2007-9 has cast in doubt
the three pillars of modern common investment schemes.
Mutual funds (known in the UK as "unit trusts"), hedge
funds, and closed-end funds all rely on three assumptions:
Assumption number one
That risk inherent in assets such as stocks can be
"diversified away". If one divides one's capital and invests
it in a variety of financial instruments, sectors, and
markets, the overall risk of one's portfolio of investments
is lower than the risk of any single asset in said portfolio.
Yet, in the last decade, markets all over the world have
moved in tandem. These highly-correlated ups and downs
gave the lie to the belief that they were in the process of
"decoupling" and could, therefore, be expected to
fluctuate independently of each other. What the crisis has
revealed is that contagion transmission vectors and
mechanisms have actually become more potent as barriers
to flows of money and information have been lowered.
Assumption number two
That investment "experts" can and do have an advantage
in picking "winner" stocks over laymen, let alone over
random choices. Market timing coupled with access to
information and analysis were supposed to guarantee the
superior performance of professionals. Yet, they didn't.
Few investment funds beat the relevant stock indices on a
regular, consistent basis. The yields on "random walk" and
stochastic (random) investment portfolios often surpass
managed funds. Index or tracking funds (funds who
automatically invest in the stocks that compose a stock

market index) are at the top of the table, leaving "stars",
"seers", "sages", and "gurus" in the dust.
This manifest market efficiency is often attributed to the
ubiquity of capital pricing models. But, the fact that
everybody uses the same software does not necessarily
mean that everyone would make the same stock picks.
Moreover, the CAPM and similar models are now being
challenged by the discovery and incorporation of
information asymmetries into the math. Nowadays, not all
fund managers are using the same mathematical models.
A better explanation for the inability of investment experts
to beat the overall performance of the market would
perhaps be information overload. Recent studies have
shown that performance tends to deteriorate in the
presence of too much information.
Additionally, the failure of gatekeepers - from rating
agencies to regulators - to force firms to provide reliable
data on their activities and assets led to the ascendance of
insider information as the only credible substitute. But,
insider or privileged information proved to be as
misleading as publicly disclosed data. Finally, the market
acted more on noise than on signal. As we all know, noise
it perfectly randomized. Expertise and professionalism
mean nothing in a totally random market.
Assumption number three
That risk can be either diversified away or parceled out
and sold. This proved to be untenable, mainly because the
very nature of risk is still ill-understood: the samples used
in various mathematical models were biased as they relied
on data pertaining only to the recent bull market, the
longest in history.

Thus, in the process of securitization, "risk" was
dissected, bundled and sold to third parties who were
equally at a loss as to how best to evaluate it. Bewildered,
participants and markets lost their much-vaunted ability to
"discover" the correct prices of assets. Investors and banks
got spooked by this apparent and unprecedented failure
and stopped investing and lending. Illiquidity and panic
ensued.
If investment funds cannot beat the market and cannot
effectively get rid of portfolio risk, what do we need them
for?
The short answer is: because it is far more convenient to
get involved in the market through a fund than directly.
Another reason: index and tracking funds are excellent
ways to invest in a bull market.
Return

Going Bankrupt in the World

Close to 1.6 million Americans filed for personal
bankruptcy (mostly under chapter 7) in 2004 - nine times
as many (per capita) as did the denizens of the United
Kingdom (with 35,898 insolvencies). The figure in the
USA 25 years ago was 300,000. Bankruptcy has no doubt
become a growth industry. This surge was prompted by
both promiscuous legislation (in 1978) and concurrent
pro-debtor (anti-usury) decisions in the Supreme Court.
Under chapter 7, for instance, cars and homes are exempt
assets, untouchable by indignant creditors. Even under
chapter 13, debt repayments are rescheduled and spread
over 5 years to cover only a fraction of the original credit.
A new reform bill, passed in both the Senate and the
House of Representatives in April 2005 seeks to reverse
the trend by making going financial belly up a bit less
easy. The Economist noted that:
"While consumers do carry more debt than they used to,
the amount of income devoted to servicing that debt has
not gone up that much, thanks to falling interest rates
and longer maturities. Other factors must be at work;
plausible candidates include greater income volatility,

legalised gambling, bigger medical bills, increased
advertising by lawyers offering to help people in debt,
and a cultural shift that has destigmatised bankruptcy."
Personal bankruptcies are rare outside the United States.
Besides being stigmatized, such debtors surrender most of
their income and virtually all their assets to their creditors.
If the money they borrowed was spent frivolously or
recklessly - or if they have a tainted credit history borrowers are unlikely to be granted bankruptcy
protection to start with.
Still, personal bankruptcies are dwarfed by corporate
ones. In the plutocracy that the United States is fast
becoming, corporations and their directors remain largely
shielded from the consequences of the profligacy and
malfeasance of their management.
The new bill merely curtails bonus schemes to executives
and key personnel in firms under reorganization and
introduces bankruptcy trustees where the management is
suspected of fraud. Compare this to Britain where
managers are responsible for corporate debts they
knowingly incurred while the firm was insolvent.
Moreover, debts owed by individuals to firms take
precedence over all other forms of personal financial
obligations. In other words, as The Economist notes: "The
new treatment of secured car loans could put child-

support and alimony payments behind GMâ&#x20AC;&#x2122;s finance arm
in the queue."
It all starts by defaulting on an obligation. Money owed to
creditors or to suppliers is not paid on time, interest
payments due on bank loans or on corporate bonds issued
to the public are withheld. It may be a temporary problem
- or a permanent one.
As time goes by, the creditors gear up and litigate in a
court of law or in a court of arbitration. This leads to a
"technical or equity insolvency" status.
But this is not the only way a company can be rendered
insolvent. It could also run liabilities which outweigh its
assets. This is called "bankruptcy insolvency". True,
there is a debate raging as to what is the best method to
appraise the firm's assets and its liabilities. Should these
appraisals be based on market prices - or on book value?
There is no one decisive answer. In most cases, there is
strong reliance on the figures in the balance sheet.
If the negotiations with the creditors of the company (as to
how to settle the dispute arising from the company's
default) fails, the company itself can file (ask the court)
for bankruptcy in a "voluntary bankruptcy filing".
Enter the court. It is only one player (albeit, the most
important one) in this unfolding, complex drama. The

court does not participate directly in the script.
Court officials are appointed. They work hand in hand
with the representatives of the creditors (mostly lawyers)
and with the management and the owners of the defunct
company.
They face a tough decision: should they liquidate the
company? In other words, should they terminate its
business life by (among other acts) selling its assets?
The proceeds of the sale of the assets are divided (as
"bankruptcy dividend") among the creditors. It makes
sense to choose this route only if the (money) value
yielded by liquidation exceeds the money the company, as
a going concern, as a living, functioning, entity, can
generate.
The company can, thus, go into "straight bankruptcy".
The secured creditors then receive the value of the
property which was used to secure their debt (the
"collateral", or the "mortgage, lien"). Sometimes, they
receive the property itself - if it is not easy to liquidate
(sell) it.
Once the assets of the company are sold, the first to be
fully paid off are the secured creditors. Only then are the
priority creditors paid (wholly or partially).
The priority creditors include administrative debts, unpaid

wages (up to a given limit per worker), uninsured pension
claims, taxes, rents, etc.
And only if any money is left after all these payments it is
proportionally doled out to the unsecured creditors.
The USA had many versions of bankruptcy laws. There
was the 1938 Bankruptcy Act, which was followed by
amended versions in 1978, 1984, 1994, and, lately, in
2005.
Each state has modified the Federal Law to fit its special,
local conditions.
Still, a few things - the spirit of the law and its philosophy
- are common to all the versions. Arguably, the most
famous procedure is named after the chapter in the law in
which it is described, Chapter 11. Following is a brief
discussion of chapter 11 intended to demonstrate this
spirit and this philosophy.
This chapter allows for a mechanism called
"reorganization". It must be approved by two thirds of all
classes of creditors and then, again, it could be voluntary
(initiated by the company) or involuntary (initiated by one
to three of its creditors).
The American legislator set the following goals in the
bankruptcy laws:

a. To provide a fair and equitable treatment to the
holders of various classes of securities of the firm
(shares of different kinds and bonds of different
types).
b. To eliminate burdensome debt obligations, which
obstruct the proper functioning of the firm and
hinder its chances to recover and ever repay its
debts to its creditors.
c. To make sure that the new claims received by the
creditors (instead of the old, discredited, ones)
equal, at least, what they would have received in
liquidation.
Examples of such new claims: owners of debentures of
the firm can receive, instead, new, long term bonds
(known as reorganization bonds, whose interest is payable
only from profits).
Owners of subordinated debentures will, probably,
become shareholders and shareholders in the insolvent
firm usually receive no new claims.
The chapter dealing with reorganization (the famous
"Chapter 11") allows for "arrangements" to be made
between debtor and creditors: an extension or reduction of
the debts.
If the company is traded in a stock exchange, the
Securities and Exchange Commission (SEC) of the USA
advises the court as to the best procedure to adopt in case

of reorganization.
What chapter 11 teaches us is that:
American Law leans in favor of maintaining the company
as an ongoing concern. A whole is larger than the sum of
its parts - and a living business is sometimes worth more
than the sum of its assets, sold separately.
A more in-depth study of the bankruptcy laws shows that
they prescribe three ways to tackle a state of malignant
insolvency which threatens the well being and the
continued functioning of the firm:
Chapter 7 (1978 Act) - Liquidation
A District court appoints an "interim trustee" with broad
powers. Such a trustee can also be appointed at the request
of the creditors and by them. The debtor is required to file
detailed documentation and budget projections.
The Interim Trustee is empowered to do the following:
•

Liquidate property and make distribution of
liquidating dividends to creditors;

•

Make management changes;

•

Arrange unsecured financing for the firm;

•

Operate the debtor business to prevent further
losses.

By filing a bond, the debtor (really, the owners of the
debtor) is able to regain possession of the business from
the trustee.
Chapter 11 - Reorganization
Unless the court rules otherwise, the debtor remains in
possession and in control of the business and the debtor
and the creditors are allowed to work together flexibly.
They are encouraged to reach a settlement by compromise
and agreement rather than by court adjudication.
Maybe the biggest legal revolution embedded in chapter
11 is the relaxation of the age old ABSOLUTE
PRIORITY rule, that says that the claims of creditors
have categorical precedence over ownership claims.
Rather, under chapter 11, the interests of the creditors
have to be balanced with the interests of the owners and
even with the larger good of the community and society at
large.
And so, chapter 11 allows the debtor and creditors to be in
direct touch, to negotiate payment schedules, the
restructuring of old debts, even the granting of new loans
by the same disaffected creditors to the same irresponsible
debtor.
Chapter 10
Is sort of a legal hybrid, the offspring of chapters 7 and

11:
It allows for reorganization under a court appointed
independent manager (trustee) who is responsible mainly
for the filing of reorganization plans with the court - and
for verifying strict adherence to them by both debtor and
creditors.
Chapter 15
Adopts the United Nations model code on cross-border
bankruptcy of multinationals.
Despite its clarity and business orientation, many
countries found it difficult to adapt to the pragmatic, non
sentimental approach which led to the virtual elimination
of the absolute priority rule.
In England, for instance, the court appoints an official
"receiver" to manage the business and to realize the
debtor's assets on behalf of the creditors (and also of the
owners). His main task is to maximize the proceeds of the
liquidation and he continues to function until a court
settlement is decreed (or a creditor settlement is reached,
prior to adjudication). When this happens, the receivership
ends and the receiver loses his status.
The receiver takes possession (but not title) of the assets
and the affairs of a business in a receivership. He collects
rents and other income on behalf of the firm.

So, British Law is much more in favor of the creditors. It
recognizes the supremacy of their claims over the
property claims of the owners. Honoring obligations - in
the eyes of the British legislator and their courts - is the
cornerstone of efficient, thriving markets. The courts are
entrusted with the protection of this moral pillar of the
economy.
And what about developing countries and economies in
transition (themselves often heavily indebted to the rest of
the world)?
Economies in transition are in transition not only
economically - but also legally. Thus, each one adopted its
own version of the bankruptcy laws.
In Hungary, Bankruptcy is automatically triggered. Debt
for equity swaps are disallowed. Moreover, the law
provides for a very short time to reach agreement with
creditors about a reorganization of the debtor. These
features led to 4000 bankruptcies in the wake of the new
law - a number which mushroomed to 30,000 by May
1997.
In the Czech Republic, the insolvency law comprises
special cases (over-indebtedness, for instance). It
delineates two rescue programs:
a. A debt to equity swap (an alternative to
bankruptcy) supervised by the Ministry of

Privatization.
b. The Consolidation Bank (founded by the State)
can buy a firm's obligations, if it went bankrupt, at
60% of par.
But the law itself is toothless and lackadaisically applied
by the incestuous web of institutions in the country.
Between March 1993 and September 1993 there were
1000 filings for insolvency, which resulted in only 30
commenced bankruptcy procedures. There hasn't been a
single major bankruptcy in the Czech Republic since then
- and not for lack of candidates.
Poland is a special case. The pre-war (1934) law declares
bankruptcy in a state of lasting illiquidity and excessive
indebtedness. Each creditor can apply to declare a
company bankrupt. An insolvent company is obliged to
file a maximum of 2 weeks following cessation of debt
payments. There is a separate liquidation law which
allows for voluntary procedures.
Bad debts are transferred to base portfolios and have one
of three fates:
1. Reorganization, debt-consolidation (a reduction of
the debts, new terms, debt for equity swaps) and a
program of rehabilitation.
2. Sale of the corporate liabilities in auctions.
3. Classic bankruptcy (happens in 23% of the cases
of insolvency).
No one is certain what is the best model. The reason is

that no one knows the answers to the questions: are the
rights of the creditors superior to the rights of the owners?
Is it better to rehabilitate than to liquidate?
The effects of strict, liquidation-prone laws are not wholly
pernicious or wholly beneficial. Consumers borrow less
and interest rates fall - but entrepreneurs are deterred and
firms become more risk-averse.
Until such time as these questions are settled and as long
as the corporate debt crisis deepens - we will witness a
flowering of disparate versions of bankruptcy laws all
over the world.
Return

THE AUTHOR
S h m u e l ( S a m ) Va k n i n

Born in 1961 in Qiryat-Yam, Israel.
Served in the Israeli Defence Force (1979-1982) in
training and education units.

Education
Completed a few semesters in the Technion â&#x20AC;&#x201C; Israel
Institute of Technology, Haifa.
Ph.D. in Philosophy (major: Philosophy of Physics) â&#x20AC;&#x201C;
Pacific Western University, California, USA.
Graduate of numerous courses in Finance Theory and
International Trading.
Certified E-Commerce Concepts Analyst by Brainbench.
Certified in Psychological Counselling Techniques by
Brainbench.
Certified Financial Analyst by Brainbench.
Full proficiency in Hebrew and in English.

Business Experience
1980 to 1983

Founder and co-owner of a chain of computerised
information kiosks in Tel-Aviv, Israel.
1982 to 1985
Senior positions with the Nessim D. Gaon Group of
Companies in Geneva, Paris and New-York (NOGA and
APROFIM SA):
– Chief Analyst of Edible Commodities in the Group's
Headquarters in Switzerland
– Manager of the Research and Analysis Division
– Manager of the Data Processing Division
– Project Manager of the Nigerian Computerised Census
– Vice President in charge of RND and Advanced
Technologies
– Vice President in charge of Sovereign Debt Financing
1985 to 1986
Represented Canadian Venture Capital Funds in Israel.
1986 to 1987
General Manager of IPE Ltd. in London. The firm
financed international multi-lateral countertrade and
leasing transactions.

1988 to 1990
Co-founder and Director of "Mikbats-Tesuah", a portfolio
management firm based in Tel-Aviv.
Activities included large-scale portfolio management,
underwriting, forex trading and general financial advisory
services.
1990 to Present
Freelance consultant to many of Israel's Blue-Chip firms,
mainly on issues related to the capital markets in Israel,
Canada, the UK and the USA.
Consultant to foreign RND ventures and to Governments
on macro-economic matters.
Freelance journalist in various media in the United States.
1990 to 1995
President of the Israel chapter of the Professors World
Peace Academy (PWPA) and (briefly) Israel
representative of the "Washington Times".
1993 to 1994
Co-owner and Director of many business enterprises:
– The Omega and Energy Air-Conditioning Concern
– AVP Financial Consultants
– Handiman Legal Services
Total annual turnover of the group: 10 million USD.
Co-owner, Director and Finance Manager of COSTI Ltd.
– Israel's largest computerised information vendor and
developer. Raised funds through a series of private
placements locally in the USA, Canada and London.

1993 to 1996
Publisher and Editor of a Capital Markets Newsletter
distributed by subscription only to dozens of subscribers
countrywide.
In a legal precedent in 1995 â&#x20AC;&#x201C; studied in business schools
and law faculties across Israel â&#x20AC;&#x201C; was tried for his role in
an attempted takeover of Israel's Agriculture Bank.
Was interned in the State School of Prison Wardens.
Managed the Central School Library, wrote, published and
lectured on various occasions.
Managed the Internet and International News Department
of an Israeli mass media group, "Ha-Tikshoret and
Namer".
Assistant in the Law Faculty in Tel-Aviv University (to
Prof. S.G. Shoham).
1996 to 1999
Financial consultant to leading businesses in Macedonia,
Russia and the Czech Republic.
Economic commentator in "Nova Makedonija",
"Dnevnik", "Makedonija Denes", "Izvestia", "Argumenti i
Fakti", "The Middle East Times", "The New Presence",
"Central Europe Review", and other periodicals, and in
the economic programs on various channels of
Macedonian Television.
Chief Lecturer in courses in Macedonia organised by the
Agency of Privatization, by the Stock Exchange, and by
the Ministry of Trade.

1999 to 2002
Economic Advisor to the Government of the Republic of
Macedonia and to the Ministry of Finance.
2001 to 2003
Senior Business Correspondent for United Press
International (UPI).
2007 Associate Editor, Global Politician
Founding Analyst, The Analyst Network
Contributing Writer, The American Chronicle Media
Group
Expert, Self-growth.com
2008
Columnist and analyst in "Nova Makedonija", "Fokus",
and "Kapital" (Macedonian papers and newsweeklies).
Seminars and lectures on economic issues in various
forums in Macedonia.
2008Advisor to the Minister of Health of Macedonia on
healthcare reforms

1990
"Requesting My Loved One – Short Stories", Yedioth
Aharonot, Tel-Aviv, 1997
"The Suffering of Being Kafka" (electronic book of
Hebrew and English Short Fiction), Prague, 1998-2004
"The Macedonian Economy at a Crossroads – On the Way
to a Healthier Economy" (dialogues with Nikola
Gruevski), Skopje, 1998
"The Exporters' Pocketbook", Ministry of Trade, Republic
of Macedonia, Skopje, 1999
"Malignant Self Love – Narcissism Revisited", Narcissus
Publications, Prague, 1999-2007 (Read excerpts - click
here)
The Narcissism Series (e-books regarding relationships
with abusive narcissists), Prague, 1999-2007
Personality Disorders Revisited (e-book about personality
disorders), Prague, 2007
"After the Rain – How the West Lost the East", Narcissus
Publications in association with Central Europe
Review/CEENMI, Prague and Skopje, 2000
Winner of numerous awards, among them Israel's Council
of Culture and Art Prize for Maiden Prose (1997), The
Rotary Club Award for Social Studies (1976), and the
Bilateral Relations Studies Award of the American
Embassy in Israel (1978).
Hundreds of professional articles in all fields of finance
and economics, and numerous articles dealing with
geopolitical and political economic issues published in

both print and Web periodicals in many countries.
Many appearances in the electronic media on subjects in
philosophy and the sciences, and concerning economic
matters.
Write to Me:
palma@unet.com.mk
narcissisticabuse-owner@yahoogroups.com
My Web Sites:
Economy/Politics: http://ceeandbalkan.tripod.com/
Psychology: http://www.narcissistic-abuse.com/
Philosophy: http://philosophos.tripod.com/
Poetry: http://samvak.tripod.com/contents.html
Fiction: http://samvak.tripod.com/sipurim.html